Free Markets? An Urban Legend

Too many shadows, whispering voices
Faces on posters, too many choices
If, when, why, what?
How much have you got?
--Pet Shop Boys

Pundits continue to claim that the causes of current economic and financial problems relate to 'free markets run awry' and that increased regulation is necessary.

If such a statement appeared in a manuscript undergoing the rigor of peer review in the academic community, any competent reviewer would highlight the claim as 'empty' and in need of support.

Presenting compelling evidence that markets operate in a free state today would be a tall order. It's much easier to build the opposite case--that markets today are not free at all. Rather, regulation and other forms of intervention influence markets in a decisively 'controlled' fashion.

Consider, for example, some of the restraining forces that can be reasonably linked to current credit market problems. Let's make a partial list:

Federal Reserve. Through its monetary policy, the Fed essentially seeks to fix the price of money and credit. Indeed, the underlying assumption of central banking is that bureaucrats in a room know better than the markets about what the 'proper' price/supply of money and credit should be. It's no stretch to surmise that prolonged periods of keeping money and credit too 'easy' precipitates an orgy of borrowing. The data (e.g., extraordinary credit/debt levels, declining value of the US Dollar over time) support just such a relationship.

Government sponsored housing entities (GSEs). Fannie Mae (FNM) was founded in the late 1930s under the proposition that we needed government intervention to place more people in houses than free markets alone would permit. Once again, the underlying assumption is that policymakers know better than markets. Thus FNM and its younger cousing Freddie Mac (FRE) were structured to lower the cost of borrowing due to their implicit (now explicit) government backing. Thus, borrowers borrowed more and lenders lent more than they would have in an unregulated situation.

Accounting regulations. FASB and other accounting standards have made it nearly impossible for even managers inside financial organizations to understand just how much risk is on the balance sheet. Since organizations were complying with the rules, many folks (fund managers, retail investors, heck even regulators) are likely to presume that things were 'ok.' We're now facing the consequences of decision-makers complying with standards that encouraged disengagement from risk management.

FDIC and other 'endorsed' insurance. Backstopping bank deposits with a government guarantee disengages bank customers from doing due diligence when seeking a depository. Lacking incentive to seek value, customers did not buy in line with their preferences. Thus, depositers dropped funds in risky institutions. And many inefficient operators, who would otherwise be eliminated in a market-based system, have persisted.

Broker-dealer licensing. Requiring security sellers to be licensed by NASD or other agencies also offer customers less incentive to do homework when choosing financial advisors. In a free market system, principles would be forced to study scrutinize their choices before retaining an agent. Instead, lack of engagement in the process provokes an agency problem, where financial advisors and other intermediaries take excessive risk for their clients.

Bailouts during crises. The S&L crisis. The Mexican peso crisis. The Asian contagion. Long Term Capital Management. Post 9/11. Bear Stearns (BSC). AIG (AIG). Lehman (LEH). Fannie/Freddie. WaMu (WM). Wachovia (WB). The pending Bank Bailout. How many times does the government step into these crises with some sort of relief before investors understand that they will be 'helped out' if they take too much risk? Probably not many. The moral hazard issues here are obvious and active.

We could go on, of course (tax laws, Patriot Act, etc) but hopefully you get the picture. The data suggest that our markets are anything but free.

position in USD