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December 4, 2007

Robert Reich: When Caveat Emptor Doesn't Work

Robert Reich:

When Caveat Emptor Doesn't Work in China -- or in America, by Robert Reich: ...China’s problem isn't too much government intrusion into its economy; it's too little ... of the right kind. Some Chinese toy makers have used lead paint, some Chinese pet-food producers have used toxic chemicals, and makers of counterfeit toothpaste in China have used other toxins.

A basic free market principle is that when consumers cannot differentiate between risky products and good products, they’ll withdraw from the market, which is what’s happening to China’s consumer exports. China’s responsible exporters are suffering because irresponsible ones have cut corners to make fatter profits, and global consumers can't tell the difference. So the challenge for China is to rein in its rip-roaring free-market capitalists with regulations that better ensure safe products.

The American financial market is facing much the same challenge. When it became apparent that many sub-prime mortgage loans were far riskier than assumed, and were packaged with other loans, investors began withdrawing from financial instruments altogether. That's because they couldn’t figure out how much risk they had taken on. So the challenge for the United States is to rein in our rip-roaring financial capitalists with regulations that clarify risk...

The lesson on both sides of the Pacific is that free-market capitalism and government intervention are not on opposite sides of a great ideological divide. Free markets need governments to police them so buyers can be confident about what they're buying. ...

The practical question, then – in both China and America – is not whether you’re in favor of free markets or government regulation. It’s what kind of regulation is necessary to make markets work.

And a good guiding principle on market regulation is to ensure that the conditions for competitive markets are met as much as possible. In these two cases, for example, the problem is lack of information. Competitive markets assume full information is present, but as these examples show, that is not always the case.

When there is uncertainly about the quality of a product, buyers will be more cautious than they would be under the full information outcome. By helping to ensure that information is made available to both buyers and sellers, government regulation allows markets to function more competitively. Thus, these are cases where, contrary to the usual complaint, government intervention improves efficiency. Another example of this is housing. Regulations that force sellers to disclose known problems prior to sale make the market function more, not less efficiently.

Some people argue that markets will regulate themselves - that over time the cheaters will be forced from the marketplace - but the fact that these regulations were needed in the first place tells you that wasn't working out so well. In the case of housing, for example, people sell very few houses during their lifetime so reputation is not all that important. If you sell a house without disclosing problems thus getting too much money for it, and don't sell again for another ten or twenty years, it's unlikely that the buyers in the second transaction will even know about the sale of the first house so there is little chance of facing a penalty for failing to disclose, i.e. little chance of facing market discipline. Thus, there is little incentive to disclose problems on the second sale and the market failure due to lack of information will persist.

I suppose a private sector business devoted to collecting and selling such information about buyers could develop, but it didn't and such a firm is caught in a catch-22: if its business is successful so that everyone is afraid to cheat, nobody will need its services (the mere threat that these firms might come into existence does not appear to provide sufficient market discipline either). And it does not completely eliminate the problem in any case. For example, if you are elderly and you are cashing out and you know it's the last sale, why do you care what the rating agency will say on the next sale? There won't be one. Anytime there is a single sale for whatever reason and reputation is unimportant, the threat of market discipline from misrepresenting the product vanishes. Government regulation does not have these problems since it allows you to collect from the seller if problems turn up post sale that the buyer was clearly aware of. And the same outcome - full disclosure - is achieved without the fee that would need to be paid to the private sector firm.

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