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The Financial Crisis, Free Markets, and the Nirvana Fallacy:

I'm sure everyone has seen various op-eds, blog posts, and so forth proclaiming that the financial crisis shows that capitalism can't be left "unregulated", and that the end of "free market ideology" is nigh.

It seems obvious to me, though, that critics are comparing markets (which were far from unregulated) to a hypothetical, rational, efficient, regulatory system, which is a classic nirvana fallacy.

I won't dispute that many market actors--banks, bond rating agencies, mortgage companies, etc.--hardly acquitted themselves well during the housing bubble and resulting financial crash. But exactly which government actors acquitted themselves well? The public-private Fannie and Freddie Frankensteins, which helped inflate the bubble and whose bailouts will cost taxpayers tens of billions of dollars? The Treasury Department, which failed to do anything proactive to prevent the crisis, and ultimate whose reaction to it under Paulsen ranged from subdued panic to hyperactive panic? The Federal Reserve, whose monetary policies were probably the biggest villain in the whole fiasco, and whose chairman famously argued, absurdly, that housing prices nationwide could not go down because they never had before (and even more absurdly based his policies on such nonsense)? Congress, which pushed Fannie and Freddie to make ever more risky loans, berated (and regulated) financial companies for not generously lending to subprime borrowers, and not only prevented the Bush Administration from reforming Fannie and Freddie but gave them even more lending authority just as the crisis was emerging? And which then passed a "stimulus" bill full of longstanding Democratic priorities but rather short on actual stimulus? State and local governments, which spent lavishly when bubble-related tax revenues were way up, and almost none of which prudently planned for the bubble's bursting? And which bought into the "everyone should own a house mentality" to the extent that they were disinclined to use their existing regulatory powers to rein in crazy mortgage practices (like 0 down, option arms to insolvent borrowers) and indeed barely prosecuted rampant bubble-time mortgage fraud?

Sure, if you compare actual market actors to imaginary perfect government officials, government is going to come out looking like a mighty good alternative. But if you compare actual market actors to actual government actors, it hardly seems that the financial crisis shows the latter's superiority to the former, nor does it support the idea that turning over more and more of the economy to the tender mercies of government regulation is likely to benefit the public.

J.R.L.:
Our current predicament ought to be seen as proof that regulation does not work.
5.27.2009 11:46pm
Cardozo'd (www):
Look at Spanish Banks...then you'll see what proper regulation can do.
5.27.2009 11:47pm
Allan L. (mail):
FDIC did pretty well, all things considered. Failure of unregulated markets is not very compelling proof that regulation does not work.
5.27.2009 11:48pm
John (mail):
And the beauty is that government is rarely held accountable. As long as anybody involved can talk for 30 seconds without admitting he is an idiot or corrupt, enough voters tune out to insure he will continue in office.
5.27.2009 11:51pm
Gabriel McCall (mail):
Failure of unregulated markets is not very compelling proof that regulation does not work.

Um, which unregulated markets would those be?

A classic tactic of command-economy advocates is to hobble an industry with regulations, call it unregulated, and then point to its failure (caused by the regulations) as justifying even more regulation.
5.27.2009 11:56pm
DavidBernstein (mail):
Failure of unregulated markets is not very compelling proof that regulation does not work.
Since there are no "unregulated markets," it's an open question as to whether our "regulated markets" failed more because of the "markets" or more because of the "regulated." Some have primarily blamed "market greed"; others regulations like the Community Reinvestment Act. I'll stick with my position that we had a classic Austrian bubble caused by very stupid Fed policies. But rather than reiterate that point in the post above, I just figured it was worth pointing out that no matter how you slice it, "government" clearly bears some responsibility for the bubble, and didn't do a great job in preventing or managing the bubble and subsequent crisis, even when it had the authority to do so. And the absence of the exercise of existing regulatory authority, often attributed to "free market ideology," generally turns out to be government officials reacting to political incentives, which isn't going to be solved by passing more regulations.
5.27.2009 11:58pm
AnthonyJ (mail):
Pretty much all analysis of economic policy has the flaw that we have no way of testing how an alternate scheme would have behaved; there is no way of testing policy on a smaller scale. People issuing paeans to the free market are equally guilty of the nirvana fallacy. The best we can do is go "okay, current policy seems to have screwed up, let's try to change course, based on what seems to have gone wrong with the current course", and that currently seems to argue for more regulation. This theory may not be right, but it's got a better chance of being right than "Stay the course, we just didn't go far enough"
5.28.2009 12:09am
Dan Simon (mail) (www):
Personally, I find it depressing in the extreme that in the midst of a major economic crisis with fascinatingly complex origins and symptoms--one that strongly suggests that the economics profession's understanding of macroeconomics still has vast and critical gaps--most commentators can do little more than debate the crude, vague and likely irrelevant question of whether the crisis would more likely have been mitigated or exacerbated by some unspecified general increase or decrease in "government regulation".
5.28.2009 12:23am
Monty:
On the other side is be vision of the saintly corporation, that would make everyone wealthy beyond our wildest dreams, while respecting its worker due to the competative labor market, and carefully sheparding the privatized resources it uses.

History is full of examples of regulation run amok, just as it is full of examples of corporations doing pretty bad things. In either case its easy to shift the blame to the implementation, rather than the idea behind it. Regulation failed because the administrators were either misguided or incompotent. Industry failed because the harm they inflected was improperly externalized due to an imperfectly free market.

I tend to favor the free market myself, but libertarians shouldn't pretend the statists have the monopoly on the Nirvana Fallacy.
5.28.2009 12:46am
cubanbob (mail):
Regulation failed and will fail no matter what the statist proponents argue. It can't help but ultimately fail, the regulators are under the thumb of their political masters who rent themselves out cheaply.

Overall perhaps if the financial markets were not regulated we would have been better off. Without the implicit assurances issued by the government investors and depositors would have been a lot more prudent on where to invest and not as likely to have been wiped out in many cases.

As for regulation, it is needed but in sensible amounts and one must always be mindful that the regulators have their limits; by their abilities and competencies and the limits imposed on them by their masters.
5.28.2009 1:06am
JakeCollins:
Alternatively, the failure of financial regulation under Clinton and Bush could prove that conservatives and neo-liberals can't be trusted to adequately regulate markets. V's argument is analogous to saying, "the fox I bought to guard my henhouse ate all my chickens. I should give up guarding it altogether." No, you need to go out and buy a dog. Just as you should never trust a thin chef, so likewise you shouldn't trust anti-regulation ideologues to competently implement regulation. Luckily, we have a liberal Democrat in office now.
5.28.2009 1:15am
David Schwartz (mail):
The best we can do is go "okay, current policy seems to have screwed up, let's try to change course, based on what seems to have gone wrong with the current course", and that currently seems to argue for more regulation.
How does that argue for more regulation? I thought the lesson of this collapse was that economic collapse can come from an unpredictable direction. Isn't regulation based on the premise that you can predict what will go wrong?
5.28.2009 1:18am
catchy:
Well, we've got a model for how more regulation would work better: Canada, whose banking system ranks #1. They had tighter regulation on capital reserve requirements and against predatory lending. Both obviously served them well.

The failure of our regulatory bodies, gutted by those with an ideology that government regulation (almost?) always harms, does not mean they couldn't function better.

We just have to cancel out the votes of those who don't want or expect anything from government. Too often they get their wish.
5.28.2009 1:47am
Splunge:
Bernstein, it's off to the re-education camps with you. Don't you know grimy little facts must never be allowed to get in the way of a beautiful theory?
5.28.2009 1:55am
Leo Marvin (mail):
David,

You seem to be conflating market regulation with overweening bureaucracy. Not so. The choice isn't Fannie or nothing. The challenge is to regulate intelligently and no more than necessary. For example, requiring banks to contribute into the deposit insurance pool is a simple, low maintenance regulation which gives consumers confidence in the security of their savings, in turn benefiting the banks themselves and the broader economy.
5.28.2009 2:40am
David M. Nieporent (www):
The challenge is to regulate intelligently and no more than necessary.
You're making DB's point exactly. You're comparing stupid or insufficient regulation to a purely hypothetical intelligent and sufficient regulation, and (surprise!) the latter comes out better in the comparison. Of course, that's always going to be true.

The problem is that you go to war with the regulation you have, not the regulation you want. There are no regulations handed down from Mount Sinai; all regulations are the product of the political process, with all that implies, implemented by bureaucrats who may or may not know what they're doing (or care), etc.

The issue is whether the actual regulations Washington is likely to hand down are better than deregulation.
5.28.2009 6:23am
Sonic Charmer (mail) (www):
I'm with Gabriel and David in the first few posts, still scratching my head trying to figure out which "markets" so many people here think are/were "unregulated".
5.28.2009 6:40am
DavidBernstein (mail):
Alternatively, the failure of financial regulation under Clinton and Bush could prove that conservatives and neo-liberals can't be trusted to adequately regulate markets. V's argument is analogous to saying, "the fox I bought to guard my henhouse ate all my chickens. I should give up guarding it altogether." No, you need to go out and buy a dog. Just as you should never trust a thin chef, so likewise you shouldn't trust anti-regulation ideologues to competently implement regulation. Luckily, we have a liberal Democrat in office now.
You're right, I forgot how vigorously Barney Frank went after Fannie and Freddie, and how Chris Dodd was all over Countrywide.
5.28.2009 8:12am
pintler:

there is no way of testing policy on a smaller scale.


Isn't the ability to do that a classic argument for federalism? If states had regulated mortgages differently, would some states have had bubbles and other not?

Isn't regulation based on the premise that you can predict what will go wrong?

I wouldn't categorize all regulation that way - basic FDIC regulation is premised more on the belief that a bank should have sufficient reserves, because something will go wrong eventually. That's a pretty safe prediction.

I don't know if you were thinking of non-financial regulation, but some OSHA regs - you must have two hand controls on the punch press - are based on the premise that if you don't, you'll lose a hand. That's a premise well supported by data, unfortunately.
5.28.2009 8:49am
Jon Roland (mail) (www):
Many things are being conflated that are not the same:

1. Markets
2. Capitalism (joint investment in capital formation)
3. Large organizations
4. Emergent behavior of too many playing the same strategy

Here is another set:

5. Bureaucratic regulation
6. Non-bureaucratic intervention

The troubles we are having stem from (3), (4), and (5), not from (1), (2), and (6), unless you count the bailouts in (6).

One can imagine a remedy like forbidding any corporate entity from holding more than $100 million in assets, or to go for more than 20 years without being liquidated. That would disperse the tendency for large organizations to defeat the market by replacing large parts of it with nonmarket operations. That would still leave the problem of (4) and measures like forbidding contracts among corporate parties lasting more than, say, five years without being renegotiated would hardly suffice.

There are many possibilities for nonbureaucratic interventions, the most obvious of which would be for grand juries to investigate corporate entities looking for pathologies that could cause trouble down the line. They might ask experts to testify but there is an important role for intelligent amateurs.

As for financial institutions, I reiterate my prediction from 1979: let everyone become his own banker, with a computing device that might look like a credit card being a fully functioning bank. This is the age of the atomization of economic functions, down to the individual level. Then we are only left with trying to find ways to constrain individuals to play partially randomized strategies.
5.28.2009 8:49am
PersonFromPorlock:
At this point, the free market is a myth, as is the notion of benevolent market regulation: what we have is universal rent-seeking, implemented by this regulation or that regulation, but regulated for the benefit of somebody for sure. Until we face up to the fundamental corruption of our politicians, there's no point in talking about which theory of good government it is they're corrupting: all corrupt systems are the same.
5.28.2009 9:04am
Leo Marvin (mail):
David M. Nieporent:

The issue is whether the actual regulations Washington is likely to hand down are better than deregulation.

That's right. And though regulation isn't an unalloyed good, neither is it always the nightmare the OP implies. I for one am glad doctors are licensed, food and drugs tested for safety and efficacy, banks required to insure their deposits, and corporate insiders prohibited from trading on insider information, just to name a few. So I stand by my statement that the challenge is to regulate intelligently and no more (or often) than necessary.


Sonic Charmer:

I'm with Gabriel and David in the first few posts, still scratching my head trying to figure out which "markets" so many people here think are/were "unregulated".

How about the market for mortgage backed derivatives that crashed, dragging the global economy down with it?
5.28.2009 9:08am
Assistant Village Idiot (mail) (www):
AnthonyJ's reasoning is good as far as it goes, but one could also take the view "the last few things we did to regulate didn't work, so let's change those." I do appreciate several commenters noting the difficulty of comparing hypotheitcal good oranges with bad apples - in either direction.

As best as I can tell, markets eventually "work," or at least operate, because they are a force of gravity. There is no guarrantee that people won't be screwed along the way, but there are at least laws and criminal penalties built up over time to punish offenders and redress some evils. Regulation, OTOH, by definition is always opening up new territory for chicanery, with no systems in place to limit that damage other than more regulation.

This would suggest a harm-reduction model of regulation rather than the usual governmental Comprehensive Solution (see also drugs, immigration, taxes). As few of our Republicans and fewer of our Democrats seem able to step back from such grand fix-it schemes, and I see little practical hope of that changing in the near future, we are in an ironic position: the people must regulate regulation itself according to a harm-reduction model.
5.28.2009 9:20am
Houston Lawyer:
I see a lot of bitching in the press about the unregulated "hedge funds". However, I don't see that we are bailing any of those guys out now.

One of the biggest problems is that the regulators want the regulated to spend their money on the priorities of the political class. I'm all for regulations that reduce moral hazard, but that's not what we have had for a while.
5.28.2009 9:47am
Mark Buehner (mail):
This is a point i've been making for a while now- we keep hearing how the market has failed and more government intervention is necessary in the future. The problem with this cycle is that statists never take government failures into the equation. Market failures demand more, bigger government, and government failures demand more, bigger government.

You simply can't underestimate the effect government has with a foot (or more) in the market! How do you compete with Freddie or Fannie without essentially getting down in the mud with them. But they have access to the printing presses and you don't- this is a recipe for even greater risks just to survive. The market had been badly distorted all along, and will be moreso now. The automotive markets are in for the same treatment. How is Ford supposed to compete with a company that can set CAFE standards?

This is a one-way road to 'soft' nationalization in several major industries. Seems all those Obama critics worried about a slippery slope to socialism were entirely wrong. We've skipped that step and are heading full bore towards communism.
5.28.2009 9:49am
Gabriel McCall (mail):
Leo Marvin: I for one am glad doctors are licensed, food and drugs tested for safety and efficacy, banks required to insure their deposits, and corporate insiders prohibited from trading on insider information, just to name a few.

There's a big jump from "I like these things" to "government is the best way to supply these things." Government licensure does not prevent malpractice. The FDA's track record is far from perfect. The SEC is even worse. If a voluntary, private certifying body starts to fail in its mission, a competitor will replace it. If a government certifying agency starts to fail in its mission, you have no other options- you generally can't even sue the certified body if it was complying with the government's obsolete standards.

There's also a big jump from "I like these things" to "nobody is allowed to have things I do not like." Why should I be forced to use only the doctors with certifications that you approve of? Why should I be denied potentially life-saving medicine which lacks a certification you demand? Why shouldn't I be allowed to invest in companies which tolerate insider trading, if I believe that's the best place for my money? Why should your policy preferences have any impact on the options available to anyone else?
5.28.2009 11:02am
rosetta's stones:
The big financial institutions know that a Rubin or a Paulsen or their ilk will always be there to advocate for them if the weather turns foul. They always have, and the treasury bails them out every time. So they act accordingly.

Coupled with this, we had a mortgage industry handing out liar loans, one of which went to my sister-in-law, and her house is in foreclosure right now. Anybody who advanced her a mortgage should be in the penitentiary.

The corrupt politicians encouraged the liar loans, and these liar loan mortgages received regulatory approval and were introduced into the investment network. The financial institutions acted per the regulatory scheme in place, and the corrupt politicians bailed them out when it all fell apart.

This was not an absence of regulation, or government involvement, because everybody was doing exactly what a corrupt government encouraged them to do, and which bailed them out for doing it.
5.28.2009 11:42am

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