This week is not an indictment of free markets

Around the world, proponents of greater government control of economic activity are arguing that the emergency measures taken by the Treasury and the Fed this week, and the financial-sector turmoil which led to them, repudiate the credibility of the market economy.

For example, in this article from the New York Times this week, French lawmaker Bernard Carayon is quoted as saying that for "evangelists of the free market, this is a painful lesson."

Former EU antitrust commissioner Mario Monti is quoted as saying that critics can now say "that even the standard-bearer of the market economy, the United States, negates its fundamental principals in its behavior."

The tendency to frame the financial-sector's problems as a case of free markets vs. government control is widespread in the media reporting of the events of the past two weeks.

For example, an NPR story from today is titled "Do Federal moves take us back to the New Deal?" In it, Clinton-era Treasury Secretary Larry Summers is quoted as saying that the idea that the government should "stand back and let the private sector sort these problems out" is "the kind of thinking that made the Depression 'Great'."

Elsewhere, an interview on the CNBC "Stock Blog" from early Thursday, before the huge rally that accompanied the first indications of a comprehensive Treasury plan to take over troubled mortgage assets, was posted under the sensationalistic title "Is This The Death of Capitalism?!"

The important point to keep clearly in mind during this week's dramatic culmination of a situation that has been building for years is the very clear role that interference with free market principles played in creating the problem.

This interference took several forms, and we and many others have pointed out these forms several times over the past months. One of the most important of them was the creation of an unprecedented amount of easy money by the Federal Reserve under Alan Greenspan, which we outline in detail in "The long shadow of the Y2K bug" as well as in earlier posts that are referenced in that piece.

Another critical but little-understood contribution was the change in accounting rules to a system known as Fair Value Accounting, which took place in the early 1990s. We pointed out how serious this problem was in a blog post on March 14, prior to the collapse of Bear Stearns.

In it, we noted that assets with real value, paying real interest, were being valued as though they were virtually worthless, because the market for those assets had frozen up. That isn't a drawback to the free market: if nobody wants to pay what you think something is worth, then in a free market you can simply decide not to sell until demand for your item returns to a level you agree with.

However, due to well-intentioned accounting changes enacted in 1991, financial firms can have a very serious problem in such a situation, because they are now forced to mark those assets to the market, even if the market has temporarily gone away. This phenomenon can easily turn into a vicious cycle, and it is exactly what happened to the financial titans that now lie in ruins after the events of the past seven days.

Two recent articles in the Wall Street Journal detail the role of this accounting regulation in the financial sector's crisis. The first is "Bad Accounting Rules Helped Sink AIG" and the second is "How to Save the Financial System."

We are not suggesting that the actions of the Federal Reserve or the decision to force mark-to-market valuation of financial assets were motivated by anything besides good intentions -- they were clearly well-intentioned efforts to respond to crises that were pressing at the time. But that is exactly the point a free-market economist would make: well-intentioned government intervention often seems like a good idea, but ends up leading to unintended consequences. Some of those consequences can turn out to be catastrophic.

The earth-shaking events of this week are not an indictment of free-markets -- they are an indictment of intervention. However, that is not the interpretation you are likely to hear from most observers.

For later posts on this same topic, see also:
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