Budget 2008: A mortgage market for lemons?

In his seminal 1970 paper, Nobel laureate George Akerlof identified a whole class of economic problems as being driven by asymmetric information between two parties involved in an exchange. Applied to the market for second-hand cars, Akerlof noted that while quality varies, only the seller knows a car’s true quality. Confronted with superficially similar cars, the buyer has no way of knowing whether she’s getting a defective used car – a ‘lemon’ – or a good one for her money. Consequently she can expect only to get a car of average quality, and is therefore unwilling to pay more than an average price. But this willingness only to pay an average price has consequences for the kind of cars that are up for sale: sellers with good quality cars will take them off the market since they’re worth more than the average price. As the good quality ones leave the market, the average quality of the remaining cars for sale declines and, by this repeated process, the whole market ultimately collapses with only the lemons remaining.

Akerlof’s ‘lemons’ problem seems to be uppermost in Alistair Darling’s mind this week as he prepares to announce the results of the Treasury’s Housing Finance Review in his first Budget this Wednesday. The fear is that mortgage markets are frozen because, just as with the second hand cars, dodgy debt is driving safe debt from the market by raising the price for all debt. This credit supply shock threatens disaster for a UK housing market already teetering on the brink thanks to a retrenchment in credit demand due to record prices, high interest rates and declining confidence. The Review is expected to announce the government’s intention to introduce a ‘gold standard’ mortgage accreditation. The aim is to unblock the mortgage lending market for more credit-worthy borrowers by solving this classic economic problem.