[Update: I've been reading a lot more about the crisis, and a lot of what I say here is wrong. For example, I assumed that financial experts knew how to evaluate the structured deals and investment vehicles, and therefore that the uncertainty arises because of the difficulty in valuing real estate. Apparently, however (and I could be wrong again), the uncertainty problem is not the real estate, or even the mortgages. It's that the financial experts were in fact unable to evaluate the subprime risk in the structured deals and investment vehicles they had built.]

This post is something of a think piece. I want to try to explain the free market approach to the current crisis, as I understand it. This is not an educational piece. I'm not writing this for your benefit. I'm just thinking out loud as a way to try to improve my own understanding of the situation. I hope I've got some of this right. Let me know if you think I've screwed it up...as I probably have.

The central problem of economics is how to allocate production and consumption most efficiently, and free-market economists believe the free market is the best solution. In the ideal case, this is not particularly controversial: Using rigorous mathematical models of some fairly reasonable definitions of "free market" and "best solution," it's easy to prove that a perfect free market will allocate resources perfectly.

Of course, our real-life markets are not perfect, and economic controversies arise over how much inefficiency is caused by those imperfections and what to do about them.

The current crisis is almost by definition the result of some sort of market failure. It started because there seems to have been a systematic error in the way that financial institutions evaluated the risks in the sub-prime mortgage market. If just a few banks had made mistakes, that would be the normal operation of the market, where businesses make their bets on what will work, and sometimes lose. It's the industry-wide nature of the losses that make this a market failure of some kind.

The reasons for this are not very clear to me. One theory is that financial managers are subject to herding effects. This happens because investors judge the skill of managers based on how they perform relative to other managers in the same sector. Consequently, managers can protect their jobs by doing the same thing as everybody else, thus insuring themselves against unusually severe failures. But not against widespread failure.

Another theory I've heard is that's it's a technology failure, in the sense that the statistical models that predict the performance of mortgages turn out not to apply well to sub-prime loans. You'd think lenders would realize this, but another theory suggests that behavior of the sub-prime market changes when lots of home buyers enter the market (possibly through a herding effect among home buyers---"The Johnsons can afford their expensive house, so maybe we can too!"). Since the sub-prime market had never before been this large, no one had detected this effect and incorporated it into the models.

Yet another theory is that incentive structures within banks encouraged managers to understate the risks of sub-prime loans in order to appear more profitable. However, that doesn't explain why senior management failed to realize that managers had such incentives, after all, they created the incentive system. Also, other businesses have investments with hard-to-quantify risks---movie studios, software developers, nightclub owners---and they haven't seen the same kinds of widespread failures.

Still another theory is that government regulation caused the problem. Government regulation is always a likely suspect for industry-wide problems because idiotic managers can only bring down the companies they work for, but idiot regulators can bring down the whole industry. In the case of the housing mess, it seems likely that government pressure to make mortgage loans to poor people has contributed to the mess. It's possible that the government pushed the entire industy into unprofitability.

This is all water under the bridge. The mortgage mess is already well underway, and there's not a lot we can do about it. We've moved on to the second phase of the crisis, which is the problems facing financial institutions that are holding all these bad loans. They seem to be having trouble getting rid of them.

That's where the Henry Paulson would like the U.S. Treasury to step in. He may believe that sellers are dumping mortgage-backed securities on the market so fast in an attempt to gain liquiditiy that they have overwhelmed buyers and forced prices below the realistic value of the underlying mortgage assets. In this case, a very large financial entity, such as the U.S. Treasury, could buy the securities in bulk right now and re-sell them later as buyers start stepping up with more reasonable offers.

Another possibility is that this is a type of market failure due to assymetric information. The ultimate value of these securites depends on the values of the homes they represent, so to properly evaluate a particular mortgage-backed security might require assessing the values of a lot of property.

To understand this theory of what's going on, it helps to think of a really exotic market such as the antiquities trade. If someone offered me some sort of Egyptian tomb carving for $7500, I would have no idea if it was a great deal or a cheap modern knock-off. Since the person making the offer knows I don't know how to evaluate Egyptian artifacts, and I know that he knows I don't know, I'd assume it's a rip-off and I wouldn't buy it. In fact, no matter what the asking price, I'd assume it was more than it's worth, and I wouldn't buy it.

Mortgage backed securities are a bit like those antiquities. The institutions that have money to buy them don't have knowledge of how to evaluate them. All that knowledge rests with the institutions that are holding the mortgages right now, and which got us into this mess in the first place.

So, buyers are too filled with fear, uncertainty, and doubt to offer what the sellers are asking, and sellers are unwilling to lower their asking prices, presumably because they believe the goods are worth more than the offers they are receiving. The market is frozen.

The theory is that if buyers had more time to sort things out, they would gather enough information to overcome their uncertainty, and their offers would rise to more realistic levels. But with the financial system crumbling, we don't have more time, so Paulson wants the Treasury to step in and buy the securities at a higher price than their last offer, thus injecting cash into the system and keeping our financial system from crashing.

Some supporters of the bailout plan argue that it could turn out to be a money-making opportunity for the government. Once the market is liquid again, the Treasury can start selling the securities back to private investors. With money flowing and enough time to do the job right, investors will be able to evaluate mortgage-backed-securities better, eliminate their uncertainty, and make an offer that is closer to the true value. The Treasury will make a profit off the higher-priced sale.

The problem with this argument is that the current market offers may already be at the true value of the securities. Buy buying above that price, the Treasury would be losing money on every transaction. Wha it comes down to is that to believe mortgage-backed-securities are a good investment at the current asking price is to believe that Paulson is right and the entire securities market is wrong.

And if mortgage-backed-securities are so hard to evaluate, how is the Treasury going to do it? It's not like they have people around who do that every day. I think Paulson has said they'd just hire the people to do it, but if it was that easy, wouldn't there be a lot of investment funds out there adding mortgage experts to their staff so they can earn those profits that everyone is saying the Treasury could be making?

So what if we don't have a bailout? The big fear on everyone's mind is a credit meltdown. As the value of asset porfolios plummet, financial institutions find it hard to borrow cash. Who would want to lend money these days to a company holding large amounts of mortgage-based securities? Or to another company holding stock in a company holding large amounts of mortgage-based securities? Or to a company that has a large oustanding loan to a company that holds stock in a company holding large amounts of mortgage-based securities? You get the idea.

With nobody willing to lend money, companies that want to borrow are going to have a tough time, and we're not just talking about financial institutions. Developers won't be able to get construction loans, so new buildings won't be built and construction workers won't earn wages. Manufacturing companies may discover that they can't get loans to buy raw materials. They won't be able to build their products, and their suppliers won't be able to sell them anything.

Companies with routine cashflow problems will find that they can't meet payroll because no one wants to lend them the money for a few weeks until payments from sales come in, and their customers won't pay them on time because they haven't received their own payments. People will find that mortages are hard to get, car loans are expensive, and their credit card company just lowered their limit. Department stores will not be able to borrow the money to stock up for Christmas.

Some people think it could take ten years before the credit markets are rebuilt and our economy starts growing again. It's a recipe for another Great Depression.

But is it for real? According to strict microeconomic theory, the story I've just told is preposterous. Borrowers take out loans because there are things they want to do with the money. Lenders make loans because they're willing to put off doing anything with their money right now in the hope of having more money to do stuff with later. Nothing in my tale of woe changes the motivations of the borrowers or the lenders.

Banks and brokerages and money market funds are all just part of the vast mechanism by which borrowers and lenders find each other and coordinate their transactions. It's complicated because borrowers have thousands of different ways to put the money to use, and all of them have to be matched to various lenders' desires for profit, risk, and liquidity. And if all that complicated mechanism goes away, lenders and borrowers will have a hard time pairing up to do deals.

But they'll still want to do deals. About as much as ever. Surely they will be able to figure something out? Free markets have proven time and again that they can adapt extremely fast to changing conditions. With our current technology---computers and the internet---it seems likely that the credit markets could rebuild themselves very quickly. Can't borrowers and lenders meet on Craigslist? If eHarmony can find your perfect mate, how hard would it be for them to find your perfect investment opportunity?

At the top of this post, I said that economics was about allocating resources. But in order to channel resources to useful enterprises, the allocation process necessarily has to take resources away from the failures.

If the convenience store on the corner isn't making money, the owner won't be able to pay his rent or meet his payroll or pay his suppliers. He'll go out of business, and his landlord will rent to a different business, his employees will go work for someone else, and the supplies he would have purchased will be bought by someone else.

Every time a firm shrinks or goes bankrupt, the economy is taking resources from one activity so they can be given to a better one. All these financial firms going bust? That's the invisible hand of the market signalling us that these firms are no longer efficient enough.

Now their analysts are on the street, and their computer software is on sale to the highest bidder. Their cubicles are stuffed into some warehouse, their computers are on Ebay, and their offices are up for rent. Cheap. These are the raw materials from which the next generation of financial institutions will be built.

The trick is to let it happen. So, for example, if Ebay figures out a way to handle commercial loans through their website, we can't afford to have the SEC tie them up in regulations for three years.

Equally important, we need to let poorly-performing enterprises crumble in order to reduce their resource usage. There is already evidence that financial companies are holding onto troubled mortgage-based securities because they are hoping to get more for them in the bailout than they can on the free market.

(The worst case---which is not at all unheard of in the history of business regulation---is that stuggling financial corporations will convince legislators and regulators to clamp down on newer and more innovative business models in the name of protecting the old businesses.)

It's my belief that if we don't have this giant bailout, we can let the worst players in the current system collapse, and we'll still get by, as long as we don't keep trying to preserve the old system, and if we resist burdening the new system with harsh regulations.