The first time we heard the term market failure we assumed the term referred to the occasional inability of market processes to withstand government interference. Later a good friend who was majoring in economics explained to us that this was not the standard understanding of the term. It was another case of our own conceptual dyslexia, where we learn last the simple things and never quite grasp by instinct what strikes everyone as obvious. But we’re stubborn and our initial impression has always colored the way we look at these things.
So the same thing happened later when someone used the term “systemic risk” in a discussion of hedge funds. We assumed they were talking about the risk posed to alternative investments by busybody regulators hungry for campaign donations. It turns out that the systemic risk wasn’t to hedge funds at all—it was a risk allegedly created by hedge funds to everyone else. Who would have thunk it?
We’re still not sure we had it wrong. With many hedge funds having been brutalized by the credit markets in recent months, it does seem that we were at least half right. The systemic risk in the financial system wasn’t being created by hedge funds, it was being absorbed by them. Without a doubt, their appetite for risk may have added to overall risk in the market. The appetite for mortgage backed derivatives, for instance, surely contributed to the mortgage bubble.
[More after the jump.]
But for all the attention paid to the alleged paucity of hedge fund regulation, doesn’t it now seem that our attention was misdirected? The original source of undue risk generation seems to have been the “ownership society” conspiracy of the federal government and the mortgage lenders, helped along by the failure to assess this risk appropriately by the ratings agencies. Investors, including many hedge funds, mispriced the risk, in part because they mispriced the risk of ratings errors.
Why all the mispricing? Is it too soon to suggest that the government and media might have had a role in all this by misdirecting our attention toward hedge funds as the sources of risk? Lawmakers and lobbyists looked at hedge funds as a source of campaign cash, and directed legislative attention in that direction. The media, for reasons we’re not sure we understand, followed along. It’s as if those charged with oversight were seeking out enemy tanks on the horizon while we waltzed through a minefield.
Which brings us back to the point we made this morning—why would anyone suppose that the people who failed so dramatically to spot the sources of risk to our markets and economy in the past few years will appropriately respond now that they are obvious to all? How come we still hear about market failures instead of government failures?