Acton Commentary

Free markets did not cause this crisis


Many assert that the ongoing financial crisis was caused by rampant capitalism and free-market economics. I disagree – not because I'm a hard-nosed conservative or a reckless libertarian, but because it's the conclusion one reaches by a reasoned analysis of the facts.

There are at least three distinct but related reasons for the crisis: the culture of greed and consumerism, irresponsible monetary policy, and misregulated financial derivatives. Are they rooted in free-market principles? Let's see.

It may be argued that greed and consumerism are potentially related to some forms of capitalist ideology. But that's debatable, because many advocates of free markets believe in the primacy of moral virtues for the functioning of markets and societies. Some also argue that it is big government, not markets, that fosters financial and economic irresponsibility.

How about irresponsible monetary policy? It may be argued that such policies are part of capitalism, but that is questionable. As the economist Jesús Huerta de Soto explains in Money, Bank Credit, and Economic Cycles (2006), inflationary monetary policies are not a natural consequence of free markets, but of government meddling with money and banking: "[T]he central bank did not emerge spontaneously as the result of market institutions, but was forcibly imposed by the government and responds to the demands of powerful pressure groups.”

The current financial system, he argues, “rests on a monopoly one government agency holds on the chief decisions regarding the type and quantity of money and credit to be created and injected into the economic system. Thus it constitutes a financial market system of 'central planning' and therefore involves a high level of intervention and is to a great extent 'socialist.'"

It is true that some advocates of free markets (think of Milton Friedman) might have been happy with Greenspanite monetary policies. But their failure to grasp their intellectual inconsistency cannot be blamed on markets.

What about the misregulation of complex financial instruments, such as the infamous over-the-counter credit derivatives? On this point, I agree that the law failed to regulate them properly. However, no advocate of free markets would say that the law should promote dishonesty.

In his eye-opening account of the history of financial derivatives, titled Infectious Greed (2003), law professor and former investment banker Frank Partnoy details how regulators were over several years pressured by special interest groups to adopt lax rules, which paved the way for the present crisis.

"There were numerous instances of the differential treatment of derivatives and equivalent financial instruments,” Partnoy explains. “Stock options were accounted for differently than other compensation expenses, prepaid swaps and other off-balance-sheet deals were recorded differently than loans, over-the-counter derivatives were exempt from securities rules applicable to economically similar deals, and swaps were regulated differently than equivalent securities. The result was a split between perceived costs (the numbers reported on corporate financial statements) and economic reality (the number reported in incomplete or misleading footnotes, or not reported at all)."

It is true that some advocates of free markets were champions of the unregulated derivatives markets. However, the misregulation of derivatives markets was economically inconsistent, and promoted financial practices that were practically equal to lying and cheating.

Partnoy raises a related issue: the failure of public authorities to prosecute and punish complex financial fraud. In the years leading to the present crisis, numerous illegalities have been committed, and lawsuits are beginning to pile up. But the record so far shows that most individuals committing such illegalities have either gone scot-free or received a mere slap on the cheek.

A central function of law is to educate citizens in virtue. Not all vices should be prohibited, and as in the education of children, the right mixture of rules and sanctions depends on the moral qualities of the people. In Wall Street, the culture of greed and the presence of strong financial incentives to engage in dubious practices should be countered by stronger sanctions. The failure of existing codes to prohibit and punish blatant acts of injustice has been fostering a law of the jungle.

In addition to stronger prosecution, Partnoy recommends moving from clear but narrow rules to broader standards in financial markets regulation. Broad standards are not only more difficult to avoid and exploit, but they would also help encourage a culture of honesty.

Various reforms are needed, but they do not consist in heavier taxes and more industry regulation. Big government will only make it more difficult for economies to adapt to the crisis situation. We must tackle the problem at its roots by defending basic principles of justice and honesty.