Capitalism works, when we like it or not

Capitalism works very well at exploiting new mechanisms to satisfy markets. That brings tremendous social benefit when the new market is for personal communication devices with easy graphical interfaces, as exemplified by Steve Jobs and the creation of the iPhone. Technological advance is the trump card of capitalism. But what about the market for tail risk? When people in the financial industry can make billions of dollars by providing a few more basis points of return, with all risk factored away, except systemic risk? There is a lot of incentive for that. And it works fine… until it builds up to a systemic collapse. Which collapse has small impact on the incentives encouraging the market that leads to the collapse. Uneasy Money makes the argument for the social detriment there. It’s worth reading, even if you disagree vehemently with the proposed solution.

It’s interesting that many defenders of capitalism want to deny its efficiency, when faced with how well the financial industry exploited the market for tail risk. Various economic blogs are pointing to a study by the Reserve Bank of St. Louis that identifies normal capitalism in the explosion of the subprime market:

We find no evidence that lenders increased subprime originations or altered pricing around the discrete eligibility cutoffs for the Government Sponsored Enterprises (GSEs) affordable housing goals or the Community Reinvestment Act. Our results indicate that the extensive purchases of risky private-label mortgage-backed securities by the GSEs were not due to affordable housing mandates.

Which should have been obvious to anyone who remembers when private subprime mortgages were the chief product hawked by spam email.

Uneasy Money also has a good post on the gold standard and recessions.