Does the Financial Crisis Discredit Libertarianism?

Writing in Slate, Jacob Weisberg claims that the financial crisis discredits libertarianism:

A source of mild entertainment amid the financial carnage has been watching libertarians scurrying to explain how the global financial crisis is the result of too much government intervention rather than too little....

[T]o summarize, the libertarian apologetics fall wildly short of providing any convincing explanation for what went wrong. The argument as a whole is reminiscent of wearying dorm-room debates that took place circa 1989 about whether the fall of the Soviet bloc demonstrated the failure of communism. Academic Marxists were never going to be convinced that anything that happened in the real world could invalidate their belief system. Utopians of the right, libertarians are just as convinced that their ideas have yet to be tried, and that they would work beautifully if we could only just have a do-over of human history...

To which the rest of us can only respond, Haven't you people done enough harm already? We have narrowly avoided a global depression and are mercifully pointed toward merely the worst recession in a long while. This is thanks to a global economic meltdown made possible by libertarian ideas.

There are several problems with Weisberg's thesis. First, the US had hardly been following free market financial policies in the years prior to the crisis. Many commentators have pointed out the central role of government sponsored enterprises (GSEs) such as Fannie and Freddie Mac in promoting subprime and other risky mortgages that investors were willing to acquire in part because they believed that the GSEs would be backed by a government bailout if anything went badly wrong. As the term "government-sponsored" implies, Fannie and Freddie were hardly free market institutions. Some libertarian-leaning scholars, such as Peter Wallison in this 2005 article, have long predicted that their policies could lead to catastrophe unless reined in. The crisis was also fueled by the Federal Reserve Board's promotion of artificially easy credit over the first half of this decade. To put it mildly, libertarians have never liked the Fed. They have have often emphasized, as I did in this April post, that it is dangerous to give a small group of government technocrats vast power over the economy.

Recent American economic policy has not been especially pro-market in areas outside finance regulation either. During his first five years in office, George W. Bush presided over the biggest expansion of government spending in decades, including a major increase in regulatory spending.

Second, even if one can say that the US was following market-based policies in recent years, the same can't be said of European nations such as Germany, Iceland, and Spain, all of which have had mortgage/financial crises at least as severe as ours. If the financial crisis discredits "libertarianism" in the US, does it also discredit German social democracy? In my view, neither is true. But Weisberg's logic points in that direction.

Finally, no ideology can be judged solely by its performance in one particular crisis. Any set of policies is imperfect and therefore may provide flawed answers in a particular situation. Here is where Weisberg's analogy with communism circa 1989 breaks down. The problem with communism was not that communists had handled some one isolated crisis poorly. It is that communism's overall record over many decades was one of repression, mass murder, and economic decline - all with few or no offsetting benefits. Economic liberalization over the last several decades, by contrast, has lifted millions out of poverty around the world and greatly increased both personal freedom and standards of living. As Gary Becker points out, the period of economic liberalization in the twenty years or so prior to Bush's "big government conservatism" saw enormous economic gains. He suggests that if today's crisis were indeed an inevitable result of that liberalization, the overall balance sheet (25 years of massive progress vs. 2-3 years of painful recession) might be worth it.

It would be foolish to completely dismiss the possibility that libertarians were overly optimistic about the virtues of unregulated financial markets. It may turn out that some new forms of finance regulation will be justified. I do not believe that libertarian thought is perfect; far from it in fact. I merely think it is better than the available alternatives.

Be that as it may, libertarianism, like other ideologies, must be judged by its overall record. And that record must be compared to the overall record of the alternatives. For example, even if new regulation is indeed needed, we must be sensitive to the danger that crises such as this one present tempting opportunities for governments to expand their power in harmful ways that go far beyond what is necessary to address the crisis itself.

Weisberg is right to predict that libertarian ideas will face an uphill political struggle over the next few years. After Obama wins, government will almost certainly expand considerably, helped by a combination of united Democratic government and a crisis atmosphere. Even if McCain somehow manages to pull out the election, things won't look too good for free market ideas. Economic crises often provide a strong impetus for government intervention and the ideologies that advocate it. I'm not convinced, however, that free market advocates will be permanently defeated. Still less do I believe that they deserve to be.

UPDATE: Matt Welch has a good response to Weisberg's piece here.


Anna Schwartz on the Economic Crisis:

Economist Anna Schwartz, Milton Friedman's coauthor on their classic work, A Monetary History of the United States, has some interesting comments on the financial crisis in this recent interview with the Wall Street Journal. She argues that the Federal Reserve's "easy credit" policy during the first half of this decade bears a large portion of the blame. The Fed's policy, of course, was one of several ways in which the current crisis was at least in part brought about by non-free market forces.


Does the Financial Crisis Discredit Libertarianism? Round II:

Arianna Huffington has a widely circulated op ed claiming that the current economic crisis discredits free markets. She provides very little in the way of evidence. There isn't much here that wasn't aired in Jacob Weisberg's similar piece back in October. So I refer interested readers to my rebuttal to Weisberg in this post. Huffington even imitates Weisberg's comparison between free market advocates and communists. This, I suppose, is the economic policy debate equivalent of comparing the Israelis to the Nazis and is about equally edifying.

Huffington also cites the recent New York Times article claiming that the crisis was caused in part by the Bush Administration's supposed commitment to free markets. I'm not going to analyze the article in detail here. However, I will note that it also emphasizes that the Bush administration engaged in considerable government intervention incentivizing financial institutions to issue mortgages to poorly qualified homebuyers as part of its policy of promoting homeownership. As the article puts it:

Mr. Bush had to, in his words, "use the mighty muscle of the federal government" to meet his goal. He proposed affordable housing tax incentives. He insisted that Fannie Mae and Freddie Mac meet ambitious new goals for low-income lending.

"Us[ing] the mighty muscle of the federal government" doesn't exactly sound like laissez-faire to me.

More generally, the notion that the Bush Administration had any serious commitment to free markets is laughable in light of the fact that it created the largest new government program in decades (the 2003 Medicare prescription drug bill), presided over the greatest expansion of government spending since the 1960s, and massively increased regulatory spending as well.


Bush is Indeed Like Herbert Hoover - But Not in the Way You Think:

In the course of a New Republic article analogizing George W. Bush to Herbert Hoover, historian Alan Brinkley perpetuates the long-discredited myth that Hoover failed to stop the Great Depression because he pursued laissez-faire policies:

Herbert Hoover . . . exemplifies the dangers of sticking to one's principles. One of the ablest and most widely admired men in America when he was elected president in 1928, Hoover left office four years later discredited and reviled--a victim of a Depression that he had not created, to be sure, but also a victim of his choice of conviction over pragmatism. Unwilling to challenge the pillars of free-market capitalism, strongly committed to balanced budgets and fiscal prudence, convinced that the natural laws of economics would bring the Depression to a close, he responded to the Depression with such restraint and timidity that had his administration not ended when it did, the entire financial system of the United States might have collapsed.

Far from being "unwilling to challenge the pillars of free-market capitalism," Hoover reacted to the Depression by promoting extensive government intervention. For example, he established the Reconstruction Finance Corporation, a new federal agency that gave massive loans and grants to banks, failing businesses and state and local governments - a policy similar to today's bailouts. He also supported (albeit reluctantly) the enactment of the Smoot-Hawley tariff, a protectionist measure intended to strengthen American businesses by shielding them from foreign competition. Furthermore, he sponsored a massive increase in federal spending on a variety of relief programs. Similar to today's Democratic Congress, Hoover sought to stimulate the economy by increasing federal funding for public works through the Emergency Relief and Construction Act.

Speaking before the 1932 Republican Convention, Hoover boasted that he had rejected the "disastrous" option of doing "nothing" and instead had "met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic." In that same 1932 campaign, FDR even denounced Hoover for overspending and promised to enact a balanced budget.

Nor were Hoover's interventionist policies a sudden change of heart caused by the Great Depression. He had advocated extensive increases in government spending and regulation for years, especially during his time as Secretary of Commerce in the 1920s. Even before the Depression began, the Hoover Administration promoted federal intervention in labor relations and massive farm subsidies.

None of this is news to economic historians. By the 1960s and 70s, research by a variety of scholars had shown that Hoover was anything but a laissez faire advocate. Liberal historian Joan Hoff Wilson's 1975 book Herbert Hoover: Forgotten Progressive is a good summary of the evidence. It is surprising that an outstanding historian like Brinkley would ignore this body of research.

Brinkley is right, however, to suggest that Hoover's policies were similar to Bush's. Like Hoover, the Bush administration responded to an economic crisis with a policy of bailouts. Also like Hoover, Bush sought to push the GOP towards big government policies long before any economic crisis had occurred. Under Bush, the GOP massively increased domestic spending and federal regulation. Bush also, in his own words,"use[d] the mighty muscle of the federal government" to incentivize financial institutions to issue mortgages to borrowers with dubious credit qualifications - an interventionist policy that helped cause the current crisis.

After Hoover left office, New Dealers used the myth of his supposed adherence to laissez-faire as a justification for discrediting free market policies. Today, we are seeing the creation of a similar myth about Bush. The truth, however, is almost the exact opposite of the myth.

The fact that Hoover and Bush pursued interventionist policies doesn't in and of itself prove that free markets are the way to go. Perhaps Hoover and Bush simply chose the wrong kinds of interventions. Nonetheless, the myth of Hoover as laissez-faire advocate was an important rhetorical prop for supporters of big government policies in the 1930s. Hopefully, it is not too late to forestall the creation of a similar convenient myth about Bush today.

UPDATE: It's worth noting that FDR strongly denounced Hoover for being overly interventionist during the 1932 campaign. He attacked what he called the GOP's "reckless and extravagant spending" and warned against Hoover's tendency to conclude that "we ought to center control of everything in Washington as rapidly as possible." The later liberal Democratic view of Hoover as a laissez-faire advocate is a post-New Deal invention. When Hoover was actually in office, most Democrats realized that he was an interventionist, and many criticized him for it.


More on Hoover as Proto-New Dealer: Herbert Hoover--the "Forgotten Progressive"--also nominated three Justices to the Supreme Court: Charles Evans Hughes (February 24, 1930--June 30, 1941) replacing Chief Justice Taft, Owen Roberts (June 2, 1930--July 31, 1945) replacing Justice Sanford, and Benjamin Cardozo (March 14, 1932--July 9, 1938). In O'Gorman and Young v. Hartford Fire Insurance Co, 282 U.S. 251 (1930), the Supreme Court began the so-called "New Deal Revolution" a few years early. In O'Gorman, it adopted what it called a "presumption of constitutionality" in place of the Progressive Era Supreme Court's requirement that a legislative interference with liberty be justified as reasonable. Here is a summary of the case from the The Oxford Companion to the Supreme Court of the United States:
O'Gorman is a turning point case in the field of economic due process. One of the last liberty of contract cases, it involved a New Jersey statute regulating the fees paid to local agents by insurance companies. The statute was challenged as a violation of the Fourteenth Amendment's Due Process Clause. Contending that the facts surrounding its origins and operation should be determinative, Justice Louis Brandeis sustained the statute. He found that the presumption of constitutionality must prevail in the absence of some factual foundation of record for overthrowing the statute" (p. 258). Further, legislative judgment must prevail unless it could be demonstrated that the measure was utterly arbitrary. No such demonstration had been made. The business of insurance, he argued further, is so far affected with a public interest that the state may regulate the rates as a subject clearly within the scope of the police power. He further contended that the Court should cease using the Due Process Clause in a "substantive" manner to second guess the legislature.

The four dissenters [Van Devanter, McReynolds, Sutherland, and Butler] vigorously propounded freedom of contract, restrictive alteration of the public interest doctrine, and the pressing obligation to check any legislative interference with property. They particularly objected to the idea that the right to regulate business implied the power to trespass on the duties of private management. The majority opinion, however, made clear that the constitutionality of state regulation of the economy should no longer turn on the question of its unreasonableness.
The vote was 5-4 with Chief Justice Hughes and Justice Roberts tipping the balance. Indeed, the case was originally argued on April 30, 1930, after Hughes replace Taft but more than a week before Hoover nominated Roberts. With the Court presumably divided 4-4, O'Gorman was held over for reargument until October 30th, after which Roberts was able to form a new majority adopting the presumption of constitutionality. (See Barry Cushman's, Rethinking the New Deal Court, p. 76.) Less than two years later, Hoover nominee Cardozo replaced Justice Brandeis who wrote the opinion in O'Gorman. In this way, it was Hoover's nominees who began seriously undermining the Due Process scrutiny of the Progressive Era Court--the approach identified with Lochner v. New York--well before Roosevelt had a chance to appoint anyone to the Supreme Court.

How the New Deal Prolonged and Deepened the Great Depression:

Economists Harold Cole and Lee Ohanian have written an interesting Wall Street Journal op ed summarizing their important research showing that the New Deal prolonged and deepend the Great Depression of the 1930s:

The New Deal is widely perceived to have ended the Great Depression, and this has led many to support a "new" New Deal to address the current crisis. But the facts do not support the perception that FDR's policies shortened the Depression, or that similar policies will pull our nation out of its current economic downturn.

The goal of the New Deal was to get Americans back to work. But the New Deal didn't restore employment. In fact, there was even less work on average during the New Deal than before FDR took office....

Why wasn't the Depression followed by a vigorous recovery, like every other cycle? It should have been. The economic fundamentals that drive all expansions were very favorable during the New Deal...

So what stopped a blockbuster recovery from ever starting? The New Deal. Some New Deal policies certainly benefited the economy by establishing a basic social safety net through Social Security and unemployment benefits, and by stabilizing the financial system through deposit insurance and the Securities Exchange Commission. But others violated the most basic economic principles by suppressing competition, and setting prices and wages in many sectors well above their normal levels. All told, these antimarket policies choked off powerful recovery forces that would have plausibly returned the economy back to trend by the mid-1930s.

As they say, read the whole thing.

I previously blogged about this issue in this post. Unfortunately, many today are bent on repeating some of the mistakes of the 1930s.

UPDATE: For those interested, here is an ungated link to Cole and Ohanian's well-known 2004 Journal of Political Economy article that provides evidence showing that the New Deal prolonged the Depression by some 6-7 years.