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In this issue, I take a break from market analysis and forecasts to address a more fundamental economics topic: the role of free economic and financial markets. Free markets certainly deserve a critical examination in light of their recent failures in the current financial crisis.

Free markets are desirable for two main reasons: (1) they protect the freedom of exchange and association and (2) they can produce efficient and prosperous economic outcomes. In this issue, I explore both and discuss the conditions under which free markets achieve them. I try to present a balanced perspective that draws from both classical and contemporary sources. In the end, I defend the important role of free markets and consider implications in the context of today's economy.

Why free markets?

Free markets allow buyers and sellers of goods and services to engage in voluntary exchange via the price system. Freedom of exchange has philosophical origins in individuals' rights to choose how and with whom they associate. If person A wants to buy some good or service from person B, who are you or I (or the government) to stop them?

Nearly 50 years ago, Milton Friedman famously described the role of economic freedom as a necessary prerequisite for political freedom:

Economic arrangements play a dual role in the promotion of a free society. On one hand, freedom in economic arrangements is itself a component of freedom broadly understood, so economic freedom is an end in itself. In the second place, economic freedom is also an indispensable means toward the achievement of political freedom. (p. 8)

...[Liberals] take the freedom of the individual, or perhaps the family, as our ultimate goal in judging social arrangements...The "really" important ethical problems are those that face an individual in a free society - what he should do with his freedom... (p.12)

...The basic problem of social organization is how to co-ordinate the economic activities of large numbers of people...[an economy of voluntary exchange can] bring about co-ordination without coercion. (p.12-13)

- Milton Friedman, Capitalism and Freedom, Chicago University Press, 1962

We value the freedom of exchange as an end in itself, but individualism aside, it is worth asking whether free markets produce desirable economic outcomes. I tend to agree with former Presidential candidate Ron Paul, who writes that he "would choose freedom even if it meant less prosperity, but thankfully we do not face such a choice." (Ron Paul, The Revolution: A Manifesto, p. 100)

The historical experience of the West provides evidence that free markets produce long-term economic growth and development. Consider the following viewpoint of two economic historians who traced the West's extraordinary economic growth back to its origins, from the Middle Ages to the Industrial Revolution to the Modern Economy. They write:

The explanation of gradual growth, so long continued, has to reside in an institutional mechanism, built deep into the structure of Western economies and continuously seeking out and adopting growth-inducing changes... (p. 7)

...Our general conclusion is that the underlying source of the West's ability to attract the lightning of economic revolutions was a unique use of experiment in technology and organization to harness resources to the satisfaction of human wants. The key elements of the system were the wide diffusion of the authority and resources necessary to experiment; an absence of more than rudimentary political and religious restrictions on experiment; and incentives which combined ample rewards for success, defined as the widespread economic use of the results of experiment, with a risk of severe penalties for failing to experiment...the thematic terms are thus autonomy, experiment, and diversity. [author's emphasis] (p. 33)

- Nathan Rosenberg and L.E. Birdzell, Jr, How the West Grew Rich, Basic Books, Inc., 1986

Free market economies fundamentally promote more autonomy, experiment, and diversity than do centrally planned economies. I think that nearly everyone would agree that free markets, properly directed, are capable of producing exceptionally prosperous economies. Where people disagree, however, is how much regulation produces the best free market outcome.

Free markets and resource misallocation in the modern economy

One of the biggest criticisms of free markets is that they can grossly misallocate economic resources. For example, the asset price bubbles in Internet Stocks or U.S. home prices caused an enormous amount of labor and investment capital to be inefficiently directed towards technology development and building houses. More recently, the financial crisis and stock market crash is said to be further evidence of a free market failure (with too many resources allocated to the financial sector).

The following quote from a Newsweek article sums up a typical criticism of free market ideology:

A source of mild entertainment amid the financial carnage has been watching libertarians scurry to explain how the financial crisis is the result of too much government intervention, not too little...But libertarian apologists fall wildly short of providing any convincing explanation for what went wrong. Like all true ideologues, they interpret mounting evidence of error as proof that they were right all along.

To which the rest of us can only respond: haven't you people done enough harm already?...

...Their heroic view of capitalism makes it difficult for them to accept that markets can be irrational, misunderstand risk and misallocate resources—or that financial systems without vigorous government oversight constitute a recipe for disaster.

- "The Libertarians’ Lament", Newsweek, October 27, 2008

Even Alan Greenspan, the former Federal Reserve Board Chairman and self-described Libertarian, expressed regret for relying on market forces to motivate market participants to make prudent and responsible financial decisions:

As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined. [emphasis mine]

- Greenspan Testimony on Sources of Financial Crisis, The Wall Street Journal, October 23, 2008

Although Greenspan identified the Internet Bubble three years before its peak in his famous 1996 "Irrational Exuberance" speech, I suspect that he failed to prick the bubble for two main reasons: (1) his inability to do so effectively and (2) his philosophical belief that it should be allowed to continue. Even with the benefit of hindsight, I'm not sure that Greenspan would have prevented investors from buying Internet Stocks at high prices because of his philosophical orientation towards freedom of exchange. Informed and competent investors should be free to exchange financial assets at whatever price they choose.

In my view, regulation in the financial sector is justified only in cases of classic economics market failures that produce inefficient outcomes (e.g. monopolies, externalities, public goods). These occur when market participants do not bear the full costs or benefits of their actions. If an investor loses his life savings in Widgets.com stock, we may feel sorry for him but ultimately only he suffers the consequences. But if the CEO of Citigroup bankrupts the company and requires a federal bailout, we all bear the costs of this poor decision.

Markets where participants internalize the full costs and benefits of their actions lead to desirable economic outcomes in the long-run. The claim of "too little regulation" is as unjustified as the claim of "too much regulation". What matters is who bears the costs and benefits of individuals' decisions. Market stability was not undermined after the Internet Bubble crash since the costs (capital losses) were concentrated among stock investors alone. The current crisis is more problematic because the costs are shared by so many individuals (rather than concentrated among the banks' shareholders and debtholders).

Free markets may misallocate resources for a time, but sooner or later reality catches up and the system corrects. Many banks failed in 2008 because their process for allocating capital (leveraged speculation on asset prices) made no sense. Ultimately, the free market should not be evaluated for whether it has perfect foresight (it doesn't!) but instead on its ability to change and adapt to favorable outcomes over time.

The 2008 financial crisis and the Bernanke doctrine

This brings us to the fundamental problem of the 2008 financial crisis. Banks are so troubled financially that they are unable to change and adapt. We would not be in crisis if one or two banks failed in isolation. The problem is that so many banks banks are failing at the same time.

But why should we care? After all, the bank's shareholders and debtholders get wiped out and everybody bears the costs of their own decisions, right? Unfortunately not. We have become so dependent on these large financial institutions to allocate capital that their collapse is devastating to the real economy. This systemic risk was not properly factored into banks' decisions and ultimately led to a poor market outcome.

The fundamental thesis of Ben Bernanke (among others) based on decades of academic research is that the Great Depression was caused by two main policy mistakes following the 1929 stock market crash: (1) preserving the value of the dollar and (2) allowing banks to collapse:

A closer look reveals that the economic repercussions of a stock market crash depend less on the severity of the crash itself than on the response of economic policymakers, particularly central bankers. After the 1929 crash, the Federal Reserve mistakenly focused its policies on preserving the gold value of the dollar rather than on stabilizing the domestic economy. By raising interest rates to protect the dollar, policymakers contributed to soaring unemployment and severe price deflation. The U.S. central bank only compounded its mistake by failing to counter the collapse of the country's banking system in the early 1930s; bank failures both intensified the monetary squeeze (since bank deposits were liquidated) and sparked a credit crunch that hurt consumers and small firms in particular. Without these policy blunders by the Federal Reserve, there is little reason to believe that the 1929 crash would have been followed by more than a moderate dip in U.S. economic activity. [emphasis mine]

- Ben Bernanke, "A Crash Course for Central Bankers", 2000

The policy prescription of Bernanke and the Obama administration (led by Economist Larry Summers, who wrote that "maintaining demand must be the over-arching macro-economic priority" in "Wake up to the dangers of a deepening crisis", The Financial Times, November 26, 2007) will be (1) to aggressively expand the money supply, (2) to save the banks at any cost, and (3) to dramatically increase regulatory oversight of the financial markets.

As I see it, the Bernanke doctrine of expanding the money supply and saving the banks is one of the biggest government interventions of all. So we should ask whether it makes sense. The argument is that the free market outcome of bank collapses and contracting credit is inefficient and socially undesirable since the costs of a real economic slowdown are not internalized by the market participants. Thus, we need a coordination mechanism (coercive government involvement via fiscal and monetary stimulus) to achieve the economically efficient outcome.

I agree that government intervention can be justified to correct this market failure (in the strict economic sense), but I have a problem with the means through which it is implemented.

I have yet to hear a reasonable explanation provided by a government official as to the policy trade-off that we face in this financial crisis. Instead, policies are rushed through Congress using scare tactics based on arguments that many economists (myself included) have a hard time understanding. Yes, the economy is complicated, but so much so that that U.S. policymakers cannot explain the basic trade-offs to the American people? Most arguments I hear sound like this: "We need to implement policy X or else the system will collapse. If you do not agree, you are either a maniac or an idiot."

I would be open to a government stimulus package if we could agree to a fair taxation plan to pay for it. What I am not in favor of is a stimulus that is funded with borrowed money. Wealth cannot be created out of thin air. The government is deliberately devaluing the dollar to avoid a contraction in economic growth, which means we pay for the stimulus through higher inflation (eventually). Taking value from people who save by devaluing the dollar seems to me to be one of the most insidious violations of individual liberty on behalf of the government.

The "too-big-to-fail" bailout policy response does not feel fair to the average person, and for good reason. Those in power are making decisions on our behalf (this is why we elect them) but without being honest and straightforward about their methods. At stake is the political and economic freedom so important to the long-term success of this country. It's worth being skeptical of our government's relentless orientation towards bailouts and regulation in times of crisis.

Where did we fail and how can we fix it?

Consider the following excerpt from one of the most thoughtful and interesting articles I have read lately:

A bit of intellectual honesty is required of free-market economists. Free markets work splendidly, in theory. But as no less a free marketer than the great Adam Smith himself observed in "The Theory of Moral Sentiments" -- the book that preceded "The Wealth of Nations" -- in application, free markets rely on specific social, moral and political institutions. These institutions must be exceedingly robust if the free market is to deliver on all of the splendid promises made for it...

...It is much easier to say "just deregulate everything" than it is to create a culture in which people believe deeply that contracts mean just what they say, business will go to those that offer the best services at the lowest price and the courts will enforce the rules fairly. Unfortunately, without such a culture, deregulation is not apt to have the desired effect, and any belief to the contrary is as utopian and delusional as the belief that the command economy would work to perfection if only it were given a fair try.

- What the free market needs, The Los Angeles Times, October 21, 2008

In my view, 'We the People' are ultimately to blame for this financial crisis. Over the last few decades and in particular the last few years, we stopped being a thoughtful, responsible, and skeptical people.

Specifically, we are to blame...

...as savers, for failing to save for a rainy day, for driving the personal savings rate down to zero, and for expecting the government to take care of us financially when we do not take care of ourselves.

...as consumers, for living beyond our means, for borrowing to consume, and for overshopping and overspending on items completely unnecessary for personal happiness.

...as homeowners, for not being skeptical of unusually high rates of home price appreciation, for hoping that home prices always go up, and for borrowing too much money to buy a home.

...as shareholders, for wanting the stock market to be a bank account with an 8% growth rate, for not demanding more transparency and risk disclosure from Wall Street banks, and for believing the Wall Street rhetoric that holding stocks for the long-term is always a good investment strategy.

...as businesspeople, for failing to communicate risks to shareholders, for forgetting the dangers of leverage, and for ignoring the social responsibility of private business.

...as citizens, for failing to be more skeptical of our government, for not worrying about how fiscal stimulus packages are funded, for not caring about economic policy until we are personally affected by a stock market crash, and for allowing our federal government to operate beyond its means.

The media and the Obama administration have been so quick to point out that you can't rely on bankers to regulate themselves. This is true, which is why we as citizens must demand more social responsibility by taking our business to bankers with integrity.

I do believe that free markets have failed to work perfectly in this instance, but I don't believe that the free market system is a failure. It is precisely the free market system that eventually forces awareness of economic mistakes.

Rather than focus on government policy to address the above issues, I think a better solution is to focus on social and moral attitudes towards money, economics, and free trade. Markets work best when values such as honesty, integrity, and responsibility are offered voluntarily by its participants rather than imposed by regulation. It's the same reason why parents prefer that their children internalize ethics and values rather than rely on obedience to authoritarian force (though from time to time punishment isn't such a bad reminder).

Government plays a crucial role in acting as a free market "referee", but strict regulatory policy is dangerous because it takes the power away from the many and puts it in the hands of the few. In the long run, preserving a free market system is more important than fixing every free market failure if we want a dynamic, innovative, and ultimately free society.

Conclusion

Free markets help to protect economic and political freedoms that have been absent in most societies throughout history. We need to treasure principles such as individual liberty and the freedom of association if we are to remain free.

Free markets produce desirable economic outcomes only when participants practice fairness, honesty, and integrity in the marketplace. Changing social attitudes is a better way to reinforce these values than direct government regulation. We need politicians and business leaders who demand the highest standards of fairness, personal responsibility, and social awareness from American citizens and corporations.

Think it cannot be done? I'd say that the long-term American experience proves otherwise.

References

Milton Friedman. Capitalism and Freedom. The University of Chicago Press. Chicago, IL. 1962.

Ron Paul. The Revolution: A Manifesto. Grand Central Publishing. New York, NY. 2008.

Nathan Rosenberg & L.E. Birdzell, Jr. How the West Grew Rich. Basic Books, Inc. New York, NY. 1986.

Ben S. Bernanke. "A Crash Course for Central Bankers". Foreign Policy. No 120. p. 49. 2000.