The Not-So-Free Market

When the federal government took over Fannie Mae and Freddie Mac, I thought little of it since they were both quasi-governmental corporations anyhow. There was always an implied blank check on the taxpayers’ wallets which was being made explicit. It bugs me that the government is in that business at all but that’s water under the bridge and I figured that most people would not hold the free market responsible for the bailout.

When Lehman Brothers and Merrill Lynch failed without government intervention, I thought that maybe the government was going to let this situation run its course. I do not pretend to suggest that there weren’t bevies of regulators overseeing these companies at every step of their fall—just that the government wasn’t acting as guarantor with our money.

But this AIG failure and subsequent takeover by the government, where the federal government has an 80% equity stake, worries me considerably. Both presidential candidates are clamoring for greater regulation and pillorying Wall Street as if it was a free-for-all casino. Pundits are wondering “if financial behemoths like AIG are too large and/or too interconnected to fail but not too smart to get themselves into situations where they need to be bailed out, then what is the case for letting private firms engage in such kinds of activities in the first place?” Can the nationalization of our financial sector be far off with this sort of hue and cry?

“What is the case for letting private firms engage in such kinds of activities in the first place?” Have we degenerated so far that this is an honest question? The case is that it is not the government’s job to manage or provide credit. The case is that people have the right to property and liberty: they can form financial institutions whose only safety net is prudent management and a sense of fiduciary obligation. In a world without a lender of last resort, they either make the right decisions or they go bust—so they don’t take unnecessary risks with the knowledge that they won’t be allowed to fail.

And what of the pretense that our financial sector is unregulated and out of control? I’d submit that it is one of the most overseen and regulated parts of the economy, second only to health care. With the Fannie Mae guarantee and the Community Reinvestment Act mandate, lenders made questionable loans because they were insulated from the accountability inherent in loans going bad. These actions provided an incentive to try for the most profit since the worst case wasn’t detrimental to the lender.

Why is the government meddling in these transactions in the first place? When a transaction like this becomes politicized, it introduces unintended consequences and unforeseen distortions. The two parties in a transaction have financial incentives to mutually benefit; government interference inevitably favors one party over the other or punishes both parties. Its only role in financial transactions is to protect the sanctity of contract, thereby establishing recourse should either party fail to adhere to the contract.

In the end, this whole financial crisis comes down to financial participants being able to shunt away risk whether by exacting Fannie Mae guarantees, insurance policies, or willful blindness. In a free market, imprudence of that sort reaps its own consequences—businesses fail and the shareholders take a big hit. In a mixed economy, the taxpayers are left holding the bag.

[UPDATE (9/18/2008): Wait, Wall Street, you’re supposed to be more confident now. Come on!]

[UPDATE (9/21/2008): Columnist Walter Williams agrees that this mess has the stink of government all over it.]

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