It’s finger-pointing time, folks. Whose fault is the ongoing financial crack-up that has hurt, angered, and frightened so many people? There is plenty of blame to go around, and the American people deserve to know the culprits. Simple justice, though, demands that the innocent not be condemned with the guilty. Already there is one innocent that has been unfairly maligned as a cause of the debacle—the free market.
As previously explained (“Anatomy of a Financial Crisis: Part I”  [Editors note: the original URL (link) referenced in this article is no longer valid, so the link has been removed.] and “Part II” [Editors note: the original URL (link) referenced in this article is no longer valid, so the link has been removed.]), the current crisis began with a real-estate bubble that morphed into a financial house of cards. The real-estate bubble was generated by the expansionary credit policy of the Federal Reserve System. The Fed, having been created by Congress to act as Uncle Sam’s banking agent, and the Fed’s policies, are emphatically not free-market phenomena.

Neither are Fannie Mae and Freddie Mac. Congress gave Fannie and Freddie a privileged status that had these effects: first, enriching their top executives along with key congressional allies (time for some ethics hearings on Capitol Hill!); second, becoming the dominant player in what historically had been a private market for home mortgages; and third, sticking the American taxpayers with hundreds of billions of dollars of bad mortgage debt. Thanks, Uncle Sam.

That having been said, the Wall Street titans that have headlined the financial crisis this year (Bear Stearns, Lehman Brothers, AIG, etc.) were not created by government. However, the problems in the financial industry have resulted from a political failure, namely, improper regulation.

Liberals repeatedly accuse conservatives of being ideologically opposed to regulation. What nonsense! Neither “free markets” nor “deregulation” mean “no rules.” On the contrary, they assume the rule of law. What they oppose is excessive, stifling, and costly overregulation. The Latin root of “regulation”—regula—means “rule” and also connotes regularity, that is, predictability and constancy as opposed to arbitrariness and privilege. No market can function without clear rules of the game, and no true defender of free markets is dogmatically “anti-regulation.” That would be absurd.

The crisis today isn’t due to an absence of regulation, but the presence of mistaken regulation. For example, the Clinton administration, invoking the Community Reinvestment Act, imposed new regulations that penalized lending institutions if they didn’t lend “enough” money in low-income neighborhoods, regardless of the credit-worthiness of the borrowers. This regulatory regime undermined the traditional, market-based practice of risk-assessment that is the primary fiduciary duty of lending institutions. Regulators forced lenders to abandon financial prudence in subservience to a political goal, and then compounded the risk by allowing the proliferation of zero-down and no- or low-documentation mortgages. These regulatory blunders have come back to haunt us. They are responsible for the current wave of mortgage defaults and foreclosures, which in turn have torpedoed mortgage-backed securities and the many layers of financial derivatives based on them.

Another instance of regulatory failure occurred in 2005, when Republicans sought to diminish the risk of an eventual collapse of Fannie and Freddie by imposing stricter capital standards on them. That attempt was blocked on a party-line vote by Democrats.

What kind of rules does a market economy need to function well? In a society of free people, the primary rule is that one person’s freedom ends when it intrudes on another person’s rights. Thus, the right of free speech doesn’t include the right to yell “Fire!” in a crowded theater. Similarly, we have a right to seek profit, but not if our actions would wreck the entire financial system and ruin others.

We need rules against dangerous excesses—things like giant investment banks leveraging shaky debt instruments by a factor of over 30-to-1 or creating hundreds of trillions of dollars’ worth of financial derivatives. In 1998, the firm Long Term Capital Management (LTCM) shook the foundations of our financial system when its $1 trillion portfolio of derivatives started to implode. That was our warning that we needed rules to protect innocent people from the fallout of a financial nuclear explosion. Sadly, we didn’t heed that warning. Firms far larger than LTCM have created over $100 trillion in derivatives, threatening the viability of our country’s financial structure. Why was this permitted?

We face a financial cataclysm, not because of market failure, but due to political failure. Government interference with free markets, combined with government’s failure to perform its primary function of protecting the people, have brought us to the brink. In the desperate attempt to postpone the day of reckoning, the only solutions being proposed are additional government interventions, even partial nationalizations, and less reliance on markets. When things continue to worsen, please, just don’t blame “free markets.” They no longer exist.
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Dr. Mark W. Hendrickson is a faculty member, economist, and contributing scholar with the Center for Vision & Values at Grove CityCollege.