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The Mathematics of the Blame Game

By Tom W. Bell and Glen Whitman

I recently received a survey of economists on the subject of the financial crisis. The primary goal is to find out what economists believe caused the crisis. The various contributing factors fall into two basic categories, which I will call ?government failure? and ?market failure.? (Those aren?t the terms used in the survey, but that?s essentially what they are.) At one point, the survey asks the respondent to assign each category a percentage score for its contribution to the crisis, with the percentages adding up to 100%. For instance, you could say government factors were responsible for 60%, market factors for 40%.

The thing is, it should be possible for the percentages to add up to more than 100%. Why? Because some part of the crisis cannot be attributed to one category or the other; it can only be attributed to both.

An analogy. Say your spending on Coke has risen from $20/month to $45/month. This is because the price has risen (from $2 to $3) and also because your consumption has gone up (from 10 to 15 bottles). The total change is $25/month. How much of the increase is attributable to higher price, and how much to higher quantity? Well, if the price hadn?t increased, you?d be spending $15/month less. If the quantity hadn?t increased, you?d be spending $15/month less. As a percentage of the total $25 increase, each factor is responsible for 60% of the total effect, for a combined percentage of 120%. How is that possible? Because $5 of the increase resulted from both price and quantity having gone up; that is, $1 more per bottle multiplied by 5 more bottles.

Okay, so that example was probably too obvious. But I think that?s exactly what we have in the financial crisis. Some amount of the crisis is attributable solely to bad government behavior (like the Community Reinvestment Act and easy credit from the Fed). Some is attributable solely to bad market behavior (like excessive optimism and lying on credit applications). And some portion of the crisis is attributable to bad government policies having exacerbated bad market behavior. For instance, Fannie Mae and Freddie Mac ? government-created entities with implicit government backing ? helped to inflate the housing bubble.

No, I don?t know what percentage should be attributed to both categories. But I think it?s probably large.

If we must lump the combined effect into one of the other two for ?blame game? purposes, there is an interesting philosophical question about where to put it. It depends a lot on what you take as given. My instinct, for instance, is to lump the combined effect into the government failure effect. Why? Because I largely take the propensities of market actors as given. Yes, people are greedy and overoptimistic and dishonest. But it was always thus. I don?t see basic human nature as fundamentally alterable. What matters, then, is whether government policy channels human nature in good or bad directions. On the other hand, if you start with government policy as given, then you?ll end up lumping the combined effect into the market failure effect. Which is the more reasonable assumption?

In addition, at least in the government category, there are two kinds of potential failure ? broadly, ?too much government? and ?too little government.? And that?s actually where a lot of the debate is taking place, since liberals seem to think the main problem was that we needed more regulations, while market-types (like me) think a large part of the problem was too many (bad) regulations in the first place. Should lack-of-regulations be considered a market failure because regulations are supposed to rein in the market, or a government failure because government actors failed to enact them? (For what it?s worth, the survey includes ?regulatory and surveillance policy? in what I?ve called the government category.)

Full post as published by Agoraphilia on November 17, 2008 (boomark / email).