A fallacy of rationality

There is much in the news about the sub-prime housing loan crisis in the US. Over the past several years, mortgage lenders made housing loans to people who would not qualify in more conservative times. Very often these loans start out with attractive low interest rates that rise later. Now many borrowers are defaulting, either when the monthly payments rise or because of other financial distress.

Two things result - more houses come on the market as borrowers attempt to sell to end their liability or as lenders foreclose. Second, lenders start tightening on credit, shrinking the pool of potential buyers. Housing prices stagnate; new housing construction drops, consumer borrowing against the equity in their homes reduces, the economy slows down, resulting in more borrowers in financial distress.

There is a lot of finger-pointing going on about unscrupulous lenders and stupid borrowers.

But perhaps one should consider the possibility that everyone was acting perfectly rationally in their own best interests. Oh, I'm sure that there are some number of cases where a mortgage broker steered a person to a more expensive loan or in general persuaded them to do something fiscally stupid.

From the borrower's perspective, in a market where housing prices have been rising steadily, it makes sense to borrow. In case of isolated financial distress - say, because of the loss of a job - the house can be sold, and one might even end up with a little money in the pocket. From the lender's perspective, this is a loan against an appreciating asset.

The problem is that everyone doing what appears rational to themselves still doesn't necessary lead to the best outcome overall.

One could say that this is because the "rationality" is based on short term calculations. If one's calculations included - how likely is it that housing will appreciate steadily for the next ten years? or how likely in ten years is an economic downturn that throws people out of work and renders them unable to make their loan payments? - then one might have a different "rational" behavior.

Moreover, if enough of long-term calculators are present, so that most loans are sound, etc., then the short-term calculators' behavior may actually be rational, i.e., if I find myself close to default, then I will be able to sell the asset and that too, at an appreciated price.

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If you think about it, environmental problems arise exactly because what is rational for everyone produces a bad outcome when done by everyone. i.e., as one individual in a vast world, my cutting trees, fishing, releasing smoke into the air, producing garbage is harmless. When everyone does it, we have deforestation, species extinction, air pollution, etc.

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The only way to let people keep doing what is "rational" for themselves but to make that computation also be rational when everyone does it is to modify the rules by adding costs in the right places. I.e., regulation can be necessary.

The problem of course, is in devising the right set of costs. A secondary problem is that admitting that regulation is necessary is anathema to most ideologues of the free market, libertarians and the like.