Wednesday, September 1, 2010

When Markets Fail

I just finished reading Broke, USA: From Pawnshops to Poverty, Inc. How the Working Poor Became Big Business by Gary Rivlin. It is a disturbing read about what Rivlin calls the "poverty industry" in the United States. Poverty is in fact a lucrative business opportunity for the many entrepreneurs that Rivlin profiles. This is a discovery not lost on major banks that now have large investments in companies that provide sub-prime loans of all types. I knew from doing research on my own book--The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy--the counterintuitive result that collectively the working poor represent an enormous source of wealth for those who know how to tap into it. Rivlin's reporting explains how the systematic stripping of resources from communities on the financial edge is accomplished.

In my book, I liken some of these payday loans, sub-prime mortgages and credit card products to old-fashioned "company stores." But, as I read Broke, USA, I was reminded of another analogy raised in the book by Stacy Mitchell-- Big-Box Swindle: The True Cost of Mega-Retailers and the Fight for America's Independent Businesses--colonialism. Mitchell reports on the systematic destruction of local economies and businesses by mega-retailers such as Wal-Mart, Home Depot, and Target. The rationale for allowing mega-retailers entrance into a community is the market demand for their products. But, often after the destruction of local businesses and jobs, there is no longer enough wealth left in the community to support these large retailers. The corporations move on, abandon their stores, and leave a shuttered main street as well. To Mitchell, this is not the free market at work. Rather, it is exploitation akin to colonialism, in which a large power imbalance allows a distant corporation to appropriate wealth for its own enrichment at the expense of a local community.

But, the question I kept wondering about was: Why doesn't the market for loans work for poor people? Much of Rivlin's reporting was about political battles fought in state legislatures, not about businesses trying to out-compete other businesses with a better product. One of Rivlin's protagonists, Martin Eakes is founder of the Center for Responsible Lending (CRL), a company that specializes in providing reasonably priced mortgages to high-risk, low-income homebuyers. Eakes argues that CRL shows that it is possible to lend at reasonable rates to "sub-prime" borrowers and make money. He contends that the usurious, triple-digit annual interest rates, routinely charged by sub-prime lenders are not necessary, and should be banned.

However, in Rivlin's narrative, Eakes spends more time joined with community activists lobbying for bills to protect consumers against predatory lending, than expanding the CRL business model to compete nationwide against the sub-prime lenders by offering a lower-priced product. It is this paradox that gnawed at me while I read the book. It was only by the end that I realized the reason the market fails for sub-prime borrowers, and why government intervention is necessary.

The argument from the sub-prime lending industry is that interest rate caps take away consumer choice. No one forces people to take-out payday loans, pawn possessions, or sign documents for sub-prime home equity loans. Because these choices are freely made, the borrowers must see some value in the loan product. If the demand for sub-prime loans didn't exist, neither would the sub-prime lenders.

I tend to have a bias in favor of these kinds of arguments. I believe that consenting adults should be free to make decisions with their money for or against products. I have also observed that in any event, markets are extremely resilient and difficult to stamp out. One only needs to look at the markets for vices--such as drugs, gambling, and prostitution--to see the futility of trying to eliminate the supply of a product or service when there clearly exists a demand.

As a result, I tend to believe that the best way to effect change is through the market. Educating consumers on how to act in their best interests is my preferred approach. My writing, in books like the Two Headed Quarter, is intended to teach consumers how to make the best choices, not to proscribe choices. Admittedly, my bias is influenced by my own societal role as an educator.

However, I also know that markets cannot solve all problems. We would not have roads, airports, the Internet, universal phone and electrical service, without the intervention of the government acting for the common good. I also know that markets can and do fail. I was never naive like Alan Greenspan, who seems to have believed that the self-correcting tendencies of markets would eventually right all wrongs. (This belief came from a man whose job was to artificially manipulate the mortgage market by raising and lowering interest rates.) As we have recently seen, market failures can be spectacular and so threatening to the financial order, that the most committed "free market" advocates will abandon their principles and grovel before Congress when their luxury lifestyles are at stake.

But, I realized by the end of the book that the problem is deeper than lack of education. For a market to work the participants must trust each other. They must act in good faith. It would be impossible to conduct business of any kind if no trust existed between the buyers and sellers. The simplest economic interactions-grocery shopping, car repair, hair styling, eating in a restaurant-could not happen. Think about the implied contract when you order food off a menu, drop your car off for an oil change, or get your hair cut. You trust in an honest delivery of the service, and the provider trusts that you will pay.

During the financial crisis of 2008, banks could not trust other banks to repay loans, and the entire system for extending credit on a daily basis to cover short-term obligations froze. Without government assurances the banking system might have collapsed, not because of a shortage of money, but because of a shortage of trust.

Many of the lending practices profiled in Broke, USA violate trust. The lenders are not acting in good faith when they sell loans to people who cannot possibly repay the money, sell unnecessary and overpriced mortgage insurance, provide less favorable loan terms when the borrower qualifies for better terms, and then sell the toxic products to investors representing them as a safe securities. It is disingenuous for the lenders to rationalize these actions by saying that they were only acting in their best financial interests, and that the borrowers and investors should have taken more care to act in their best interests because that is how free markets work.

No, free markets will not work if greed is the only motive driving them. There is a famous quote from Adam Smith that is frequently invoked to justify greed. He wrote:

"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest."

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

But, self-interest in the community setting that Smith describes is more than just maximizing income. It's also about sustaining the relationships necessary for a community to exist in the first place. The butcher, the brewer, and the baker, will not be in business for very long if greed is their only motive. They must trust in and look out for each other, or else none of them will have their needs met. Their self-interest is not just money; it includes a need for each other.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy