In every market, there are two players, the buyer and seller of a good or service. Open competition between multiple buyers and multiple sellers create a reality economy. Government interference to help the buyer or help the seller in a market creates an entitlement economy.
An active competition between buyers and sellers determines the fair market price. When there isn't competition between sellers, the price of the good and service will be too high. Likewise, if there isn't competition between buyers, the price will be too low.
When competition between buyers is low, prices will be low and the market doesn't provide an incentive to improve the product or service. Sellers will choose to leave the market and slowly the prices will rise to a point where there is an equal number of sellers and buyers. This is called a market equilibrium.
When competition between buyers is high, meaning buyers outnumber sellers, prices go up. As prices rise, more sellers will be attracted to the market. If the competition between sellers is high, there is an incentive to improve the product or service.
When a person goes to work, they exchange their labor for a common currency. The purchaser of that labor, in turn, sells that labor in the open market. If they sell that labor for the same, or less than the amount as they paid for it, they lose money. They price their labor on the open market by only one qualification, the amount the market is willing to pay for it.
Why is this important?
Every economic bubble, such as the housing bubble we are experiencing today, was created by non market economics. The market of buyers was artificially stimulated by forces other than a reality market economy. By creating more buyers than sellers, prices rose to meet the increased demand.
How can demand be created by other than market forces?
One way is for speculation to enter the market. Speculation is a market driven phenomenon which takes away market economics. For example, the dot com bubble was created by speculators in an economic system where market economics temporarily didn't exist. Speculative markets will self correct when businesses do not make money.
Government artificially creates demand by subsidizing the buyer or seller or mandating a marketplace where one didn't previously exist. In the housing bubble, government made it easier for buyers to get access to money. They did this buy creating government programs to guarantee mortgages written in the free market. Government agreed to take out the risk of lending using government sponsored entities such as Fannie Mae and Freddie Mac. They owned or guaranteed half of the home loans in the United States.
Further demand was created by creating competition between government entities and the private sector companies. When the private mortgage industry competed with a government industry, an entitlement economy was created and the law of unintended consequences took over. Sub prime mortgages were made to people who could not meet market economic realities. Loans were given to people who could not afford homes because government encouraged businesses to make loans to them. In an effort to get more people to qualify, loans were created that didn't meet reality market conditions. Adjustible rate mortgages, 100% financing, and interest only loans were encouraged.
What should we learn about this housing bubble?
If it sounds too good to be true, it generally is. A free market reality economy exists when a buyer assumes the risk of taking out the loan, and a seller assumes the risk of making the loan. A buyer must have something to lose, which means they need to put up a down payment. A seller must have something to gain, a profit. Anything else is simply a state controlled economy and it will never work long term.
Can we apply these lessons to other markets?
Absolutely. Take the ethanol industry. The government guaranteed the demand for ethanol by creating a 5 billion gallon mandate. This is an entitlement economy, not a free market economy. This was done first to "create another market" for corn. Second, the market was created to "eliminate pollution," Finally, it was sold as a way of "lessening our dependance on foreign oil."
It needs to be stressed that there has never been buyers of ethanol because it was cheaper or better than the alternatives. The entire market was created by an artificial government demand. Incredible amounts of money must be spent by private companies in order to invest in infrastructure to accommodate this mandate. Oil companies must expend resources to mix gasoline with ethanol. Transportation companies must ship this gasoline with extra equipment, mainly separate rail cars and tanker trucks. Gas stations must install extra holding tanks and pumps to distribute this product. Auto manufactures must invest money in research and design of engines and technology to utilize ethanol and the myriad of products. State governments give up tax dollars from gas production. Millions of dollars must be spent on government lobbyists and trade associations dedicated at proving the necessity of the subsidy. Increased amounts of demand corn increases production acres for corn, which either adds more acres in production, or a transfer from other crops. An increased acreage for crops increases the demand for fertilizers, herbicides, pesticides, seed corn and a myriad of other services, as well as the cost of land, driving up prices for production.
One simple mandate creates a bunch of unintended consequences that are difficult to quantify. How much has the increased demand for corn increased the price of corn? How much more does the cost of corn affect the cost of beef, poultry and pork? If you listen to the corn lobbyists, the cost of food has not gone up because of ethanol. If you listen to the animal producers, you will hear a different story.
One thing is certain. The first reason ethanol producers wanted to produce ethanol, was to create more demand for the product. They wanted to increase demand in order to increase prices for corn. For them to now say ethanol doesn't increase prices of food goes against the reason they wanted ethanol in the first place-that it would increase demand for corn.
Any time entitlement economics is employed, the long term unintended consequences will cause an improper investment of resources and the costs will be greater than the initial benefits. Whether I am for or against ethanol is immaterial. What is important is that people understand that the same economic problems will be created by ethanol as the housing bubble.
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