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"As in a Bomb Going Off"

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The free market has taken an enormous amount of abuse as regards the current financial crisis.  It shouldn’t; it had nothing to do with it, as many of the other authors in this series have pointed out (and will).  To the extent that the market has failed, it has done so largely because of government coercion over the years.

The “free market” did not get us into this mess, but we need the free market to get us out.  For that to happen, the free market needs government as a partner, whether conservatives like that idea or not.

Free markets have always had booms and busts.  This is the nature of Schumpeter’s “creative destruction,” of which some think this crisis is just another example.  Some think this would be good for our economy.

They are wrong.  Those who see in the current crisis only creative destruction underestimate the dose of simple destruction – as in a bomb going off – we are facing, and the magnitude of that destruction.

In creative destruction the boom that follows the bust needs to have credit to stoke its engines.  The genius of capitalism is the movement of capital from the investor who seeks returns to the entrepreneur whose new innovation will help drive the next boom.

The current crisis threatens the engine of capitalism – finance – and hence we cannot sit idly by as the crisis deepens.

Financial markets are susceptible to a variety of maladies.  Gearing is the ratio of an owner’s equity to borrowed funds.  The use of derivatives – themselves the result of innovation – created an ability to leverage assets like our world has never seen.  One of these innovations are insurance policies investors could buy to protect them against the default of another firm.  This innovation – that a private firm could insure against the defaults of many other firms – ended up assisting firms in gearing, and was in retrospect a mistake.

Free markets are not free of mistakes; they just make fewer mistakes than governments.  When a big enough mistake is made by either government or the market, panic ensues.

Panics are not new, and neither are the solutions.  Panics have occurred when we have had central banks and when we have not (e.g., 1907 and 1929.)  The history of those panics before the founding of the Federal Reserve was largely of liquidity crises:  Many banks had assets greater than liabilities, but no ability to convert them to cash.  In those times with smaller, more national than international markets, private banks could and did work together to solve their problems without government help. 

But we suffer from more than a liquidity crisis at this time, and the most disconcerting for the free marketer is that many assets and derivatives on the banks’ balance sheets have an undetermined price.  Mortgages on real properties are relatively easy to liquidate, but some other bank assets are relatively new securities innovations that turned out to be bad ideas.  How these will be liquidated is unknown.

Ideally the government can act as a “market maker of last resort” in these securities, just as the Federal Reserve was envisioned as a lender of last resort for the liquidity crises of old.  If the government can create a market where none exists, our system might recover without too much violence done to it.

Free markets do not mean always private markets.  Free markets mean markets with an absence of coercion.  It is possible for government to step forward for a missing market and not be coercive.  A bailout that did not consume taxpayer dollars would be one example.  Forcing banks to alter their lending standards would be coercive and unfree. 

The problem we face is the absence of a market.  Government can help create a free market where none exists today, and that would be a good thing.  It may be that we cannot avoid costs associated with previous government meddling in the market that helped create this crisis, but we can all hope that the costs will not extend beyond those already sunk.

King Banaian is a professor of economics at St. Cloud State University and an economics fellow with the Minnesota Free Market Institute.

This commentary originally appeared in Volume 4 of "What's a Free Marketeer to Think?"
Click here to read the entire volume.

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