(This article appeared on Forbes.com on 9/18/08)
The collapse of Bear Stearns and Lehman Brothers, and the bailouts of Fannie Mae, Freddie Mac and AIG, have led to an inevitable call for more regulation. Obama promises “real” regulation. McCain will “reform Wall Street.”
The consensus is that Something Must Be Done to rein in financial markets. This consensus is part of a general theme among some pundits and economists that it’s time to give up the naïve faith that markets can solve every problem. We are told that markets have failed.
Yet much of the current chaos is the result of attempts to steer or control markets rather than let them be. Much of the chaos is the result of political failure.
In the wake of Hurricane Ike, customers wait in line for hours to buy gasoline, the inevitable result of anti-gouging ordinances that discourage retailers from raising prices and letting markets clear.
Ethanol mandates and subsidies try to create less carbon in the atmosphere than the market would create on its own. The result has been a worldwide increase in the price of corn that has hurt poor people around the world. The environmental benefits are negligible.
The turmoil in the housing market and the resulting financial crisis is just the latest example of political failure. Politicians wanted more home ownership than the market produces on its own, especially among low-income families. To encourage this politically popular goal, Fannie Mae (nyse: FNM – news – people ) and Freddie Mac (nyse: FRE – news – people ) were allowed to privatize their profits and socialize their losses. At the same time, Housing and Urban Development (HUD) required them to expand their commitment to affordable housing. Freddie and Fannie achieved this goal by buying bundles of subprime mortgages.
Now taxpayers are on the hook for at least $200 billion, and the dominoes are still falling. The real cost of this failure is that the return to housing was artificially inflated, funneling billions of dollars of capital into housing instead of more productive assets.
Politicians and policy makers ignored the essentially organic nature of market forces and assumed that one piece of the market could be altered while everything else remained unchanged. But politicians always think they can design a market from the top down as long as just the right regulations are put in place.
And they will tell us that the right regulations can be put into place to patch things up. Color me skeptical.
Going forward, the first order of business is the same as a doctor’s obligation when dealing with the complexity of the human body–to do no harm.
Unfortunately, the most recent actions of policy makers have already done immense harm. By not providing the data or information or decision rules that cause one company to be bailed out and another to go bankrupt, they have weakened the faith of the American people in the fairness of the financial system.
By sparing some reckless investors but not others, they have signaled that risk-taking results in arbitrary rewards and prudence will be punished.
By failing to highlight the role of government in creating the current crisis, they have encouraged citizens to believe that markets have failed.
Both presidential candidates will promise a risk-free world with high returns. But peddling that fantasy is the cause of the current crisis. We treat our children this way–we do our best to insulate them from harm and still allow them to grow. I’d like politicians to treat me as an adult, paying the price for my recklessness and reaping a reward when I am prudent. Returning to that world, the world of markets, is the beginning of a return to stability.