From Laissez-Faire to Market Failures

The 2008 market failure sparked significant discussions on government housing policies and reckless risk-taking behaviors. It also prompted serious reassessment of laissez-faire economics, which advocates minimal government intervention. Classical economics posited that markets are self-correcting, assuming people inherently make rational choices. This belief was in ascendancy leading up to the 2008 financial crisis. Policymakers and classical economists were optimistically complacent in their laissez-faire approach: as long as the markets remained open with minimum intervention, industries were deregulated, and inflations were under control, markets would continue to thrive independently. However, reality shatters this optimistic belief. People are not invariably rational; laissez-faire often leads to market crises. This paper examines how markets fail from the perspectives of the Minsky hypothesis, the prisoner’s dilemma, and herd mentality.

In utopian economics, markets stabilize themselves. Prices adjust accordingly to keep supply and demand at equilibrium, individuals behave rationally to maximize their utility. This pursuit of individual self-interest, described by Adam Smith’s euphemistic invisible hand, inadvertently contributes to overall societal welfare. Conventional economists believe that under laissez-faire policies, markets inherently move towards equilibrium and efficiently allocate resources. However, Hyman Minsky, a Keynesian economist, asserts laissez-faire is a utopia.

Minsky advocated government interventions to prevent economic crises. He believed that markets are naturally unstable due to the irresponsible actions of financial agents, such as bankers and traders. According to his hypothesis, financial markets will become complacent during times of expansion, and financial agents will increase their risk appetite, leading to overall financial fragility. Without preventative regulations, capitalist economies face periodic blowups.

In Minsky’s 1992 paper, The Financial Instability Hypothesis, he outlined three economic stages: hedge, speculative and Ponzi finances. He suggested that the initial hedge finance stage, though sustainable, fosters complacency, leading to speculation on future cash flows in the second stage. Ultimately, continuous speculations precipitate catastrophic financial outcomes in the Ponzi finance stage, where market participants bet on the market conditions. The 2008 subprime mortgage crisis exemplified this economic cycle, as investors speculated on both future cash flows and the market conditions. “We are in the midst of a Minsky moment”, remarked Paul McCulley in 2007, a managing director of PIMCO. He continued “bordering on a Minsky meltdown”.

Market participants had been betting on the future cash flows in the years preceding the financial collapse. Financial institutions bundled thousands of mortgages, including both prime and subprime, into Mortgage-backed-securities (MBS) and collateralized debt obligations (CDOs). The value of these securities depended on the expected future cash flows of the underlying loans, which came from the monthly mortgage payments of the homeowners. Speculation arose when market participants largely underestimated the associated risks and ignored lenders’ fraudulent lending practices. The false belief in the indefinite boom of the housing market created an irrational anticipations of uninterrupted cash flows from the mortgage payments.

Unfortunately, housing prices began to decline in 2006, mortgage delinquencies arose significantly, leading to the failure of materializing the expected cash flows. The value of MBS and CDOs plunged, causing substantial losses for investors. Instability spread across the entire financial system, triggering a broader financial crisis. Should the government rely on the invisible hand to correct the market? Minsky prescribed the answer in his book Stabilizing an Unstable Economy: “The Federal Reserve needs to guide the evolution of financial institutions by favoring stability-enhancing and discourage instability-augmenting institutions and practices”. Sadly, “Minsky was considered somewhat of a radical”, remarked Justin Lahart from the Journal.

The market failed to correct itself because market players were trapped in the prisoner’s dilemma, acting in self-interest and leading to a collectively inferior outcome. In laissez-faire philosophy, the pursuit of self-interest fuels market dynamics. However, people’s decisions are interdependent. What one person or firm does affects another’s welfare, influencing responses. These choices do not necessarily yield optimal outcomes, violating the fundamental assumption in conventional economics, as illustrated by the prisoner’s dilemma.

In the dilemma, two suspects are interrogated separately for a joint crime. If they both deny, the punishment would be minimum, resulting in a collectively optimized outcome. If they both confess, the police get two convictions. The twist is if one denies while the other confesses, the confessor is cleared, and the denier receives a heavy sentence.

Both suspects end up confessing despite the collective outcome being sub-optimal. In the prisoner’s dilemma, confessing dominates decisions due to individuals seeking to reduce punishments, acting in self-interest, but it leads to a collectively worse-off situation. The following matrix represents the prisoner’s dilemma, where the numbers refer to the utility received from the length of sentences. The payoff combination of (1, 1) is inferior to (2, 2).

Prior to the 2008 crisis, market players - lenders, subprime borrowers, and credit rating agencies – found themselves ensnared in their own prisoner’s dilemma. For lenders, increasing market share was their self-interest. They chose to relax their lending standards to expand their slice of pie, with many crossing legal boundaries. Borrowers, seeking loans for home purchases, pursued their own interest, with some providing false financial information, either voluntarily or forcefully. The credit rating agencies, fearing losses of clients to opponents, opted to turn a blind eye on the credit qualities. Theses pursuits of self-interest collectively contributed to the ultimate collapse of the financial system.

The prisoner’s dilemma captures certain underlying causes of the 2008 breakdown. Individuals make choices that, though ostensibly rational, ultimately resulting in an overall inferior outcome. In various scenarios, individuals’ choices can be fundamentally irrational, such as exhibiting herd behaviors, which again challenge the rationality assumption underlying laissez-faire. Herd behavior in finance often amplifies market trends and results in bubbles.

Behavioral economists describe herd behavior as a phenomenon in which individuals conform to group opinions without critically and independently evaluating them. Under the assumption of rationality, investors would invariably buy stocks that they think undervalued and sell stocks that they consider overvalued. The stock market would maintain equilibrium due to investors’ rational choices. However, likely occurrences would be investors following others without much independent evaluation and judgement, leading to inflated prices that eventually collapse.

Herd behaviors played a significant role in the 2008 meltdown, evident in various aspects, such as investors speculating on MBS and CDOs, and lenders aggressively issuing risky loans. Well before the market crash, MBS and CDOs were perceived as lucrative investments. These securities yielded higher returns due to their associated risks. Subprime borrowers, with lower credit scores compared to prime borrowers, were charged higher interests to compensate for the increased risk of defaulting, generating higher cash flows on MBS and CDOs.

Investors blindly followed the crowd and heavily invested in MBS and CDOs, despite these securities being largely overvalued. They disregarded the risks associated with the credit qualities and the possibility of declines in housing prices, inflating bubbles in the subprime market. Aggressive lending practices among banks prevailed during this period. Seeking to increase market shares, banks loosened lending standards, with many even crossing legal boundaries by falsifying borrowers’ creditworthiness. Lenders aggressively issued loans and recklessly preyed on the vulnerable subprime borrowers. Even as the risks became increasingly evident, herd behaviors persisted to inflate the bubble due to the opportunistic belief that catastrophic outcomes would not occur if everyone else was engaging in the same practices, contradicting the assumption of rationality.

Angelo Mozilo, CEO of Countrywide, epitomized herd mentality with his decision to increase the firm’s subprime market shares. While being aware of the risks associated with the loans that Countrywide originated, as the subprime market kept expanding, Mozilo silently permitted these aggressive lending practices to boost Countrywide’s market share. Similarly, Citigroup, despite the growing risks in the subprime mortgage market, continued to increase its investments in CDOs, resulting in significantly increased risk exposure to the super-senior CDO tranches. Those top financial executives were not alone.

Could these financial elites not have foreseen the consequences that such risks would bring? They could have, as Charles Prince, Citigroup’s former CEO, remarked in July 2007 “when the music stops, in terms of liquidity, things will be complicated”. However, the market was overwhelmingly practicing the same behaviors. “As long as the music is playing, you’ve got to get up and dance. We’re still dancing”. Herd mentality was perfectly echoed in Prince’s remarks. Such behaviors quickly inflated the intrinsic values of MBS and CDOs. Eventually, the music stopped, bubbles burst, and collective punishment ensued.

Prior to the 2008 crisis, policymakers firmly leaned on laissez-faire philosophy for economic policymaking. However, classical economic theories were constrained by the assumption of rationality. In reality, people are not rational beings. Stability can paradoxically breed instability, as warned by Hyman Minsky; individual rational choices can generate collectively inferior outcomes, as illustrated by the prisoner’s dilemma; and individuals decisions are often influenced by the group, fueling irrational choices, as depicted in herd behaviors. Markets are not self-stabilizing entities; economic policies must incorporate these insights to prevent next major crisis.