Big Government Failed Us, Not Free Markets

The sharp downturn in the economy which began a few years ago has led many people to realize that drastic changes are needed if we want to see the creation of a sustainable and prosperous society. While suggestions and opinions on what needs to be done to fix what ills the economy are many, the majority in the mainstream media and most politicians seem to believe that ultimately a return to prosperity can only be achieved through an increase in government regulation and spending, or in other words an overall increase in the size of government. These talking heads state that a drastic increase in the size and influence of government is needed because what brought us into this mess was a failure of the free market. Not surprisingly, given the bombardment of these views through essentially all mainstream forms of media (television, newspaper, magazines etc..) and amongst almost all politicians, these views have been adopted and accepted by the majority of the population. However, this is extremely dangerous as these views could not be further from the truth as it was certainly not a failure of free markets that led us into our current situation, but instead a massive failure of government. If one understands what a free market is, an examination of the American economy will reveal that not only has a free market never existed, but furthermore, the area of the economy that was most influential in causing the crisis was not characterized by free market principles, but instead riddled by government intervention.

Looking at the economic crisis in a logical manner, if one is going to make the argument that free market economics is what led us into this mess, then undoubtedly any sane person would agree that in fact a free market economic system would have to exist or existed at some time in the past for this argument to make any sense. While the logical requirement that a free market system must exist of have existed for it to be the cause of the economic crisis may seem blatantly obvious, the fact that this logic has been overlooked by so many people (economists, politicians, media talking heads etc..) is truly quite scary. There is no doubt that at certain times throughout history the US economy has operated in a manner that more closely resembles free market capitalism then at other times, but if one understands what a free market is, then by examining the history of America it will quickly become obvious that a true free market system has never existed. The following passage from economist Murray Rothbard provides a good summary of what exactly a free market is:

"The free market is a summary term for an array of exchanges that take place in a society. Each exchange is undertaken as a voluntary agreement between two people or between groups of people represented by agents. These two individuals (or agents) exchange two economic goods, either tangible commodities or nontangible services. Thus, when I buy a newspaper from a news dealer for fifty cents, the news dealer and I exchange two commodities: I give up fifty cents, and the news dealer gives up the newspaper. Or if I work for a corporation, I exchange my labor services, in a mutually agreed way, for a monetary salary; here the corporation is represented by a manager (an agent) with the authority to hire. Both parties undertake the exchange because each expects to gain from it. Also, each will repeat the exchange next time (or refuse to) because his expectation has proved correct (or incorrect) in the recent past. Trade, or exchange, is engaged precisely because both parties benefit; if they did not expect to gain, they would not agree to the exchange."

The key to a free market economic system is the ability for all individuals to undertake actions based on their free will, without coercion or fraud. This means that a true free market will be void of government intervention; no regulation, no subsidies, no bailouts, no government monopolies, and no fiat currencies (i.e. paper monies printed at will by a single institution), as all of these actions are forms of either coercion or fraud, whether one wants to believe it or not. Some people will try to point to the period when America first came into existence as a time which saw a free market economic system, however, this was simply not the case for one crucial reason, the existence of slavery. Slavery in the United States basically existed from when English colonists first settled in 1607 until the passage of the thirteenth amendment to the Constitution in 1865. Thus, up until this time the US economy was nowhere near to being free, as for a free market economic system to exist full freedom must be permitted to all individuals, regardless of race. Even after the abolition of slavery the economy still experienced significant amounts of government intervention, from military drafts during the Civil War, tariffs and other forms of protectionism throughout almost the entire history of America, and required income taxes (seen during the Civil War, 1890s, then permanently in 1913). However, one of the most significant interventions made by the United States government which altered the economy drastically and even played a significant role in the present crisis, was the creation of the Federal Reserve Bank (the Fed) in 1913, and the subsequent move to a fiat currency. The Fed harnesses a monopoly power over the production of money in the United States, and a free market cannot coexist in the presence of an institution with such concentrated power. For this monopoly allows the government (through actions by the Fed) to transfer wealth away from private hands into their control (through inflating the money supply) in a fraudulent and involuntary manner (more on the monopoly of money can be found here). If one further examines the history of the American economy they will find countless other examples of government intervention in the economy which only provide further proof that a free market economic system has never existed.

While most can probably accept that a true free market economy has never existed in America, some may still try and blame the current economic situation on capitalism or free markets by saying that the areas of the economy which led us to the crisis were in fact the most free. However, again this argument can easily be discredited as reality definitely paints a different picture. Without going into too much detail, the sector which was most influential in leading us to the economic collapse was the mortgage industry. The influence of the mortgages industry was significant as it led to the massive bubble in housing, and it was when this housing bubble exploded that the economy really began to take a turn of the worse. However, if one examines the mortgage industry they will see that this it was not a free market controlled by agents making free decisions absent of the influence of government, but instead an industry whose actions were driven by the distorted conditions created by the government and various government institutions. The collapse of the mortgage industry was in a large part due to the faulty assumption that housing prices would continue to rise at an average of 6-7% a year as this assumption led banks and other financial institutions to maintain extremely low lending standards issuing mortgages to individuals whose credit worthiness was no where near of deserving a mortgage. These lax lending standards were not too much of a problem up until 2006 because from about 1998 until about the third quarter of 2006 home prices rose in a dramatic fashion. This meant that those who could not continue to make their mortgage payments could either sell their home, usually at a price significantly higher then what they bought it at, or easily refinance the mortgage. These options for those struggling to meet their mortgage obligations quickly disappeared when home price began to fall in late 2006, leading to a dramatic increase in mortgage defaults. The increase in mortgage defaults led to a substantial increase in the supply of housing which put further downward pressure on prices, leading to further declines in housing prices and ultimately to the bursting of the housing bubble.

The bursting of the housing bubble was obviously extremely harmful to mortgage lenders as it left them with a huge supply of houses which they had obtained from those who had defaulted, but because prices were now quickly declining these homes were in many cases worth less then the amount the mortgage had been issued for. However, the damage did not stay confined to mortgage lenders, but in fact as we all know, quickly spread to virtually all areas of the economy and this was in a large part due to the existence of what is known as the secondary mortgage market. The secondary mortgage market is where banks and other mortgage lenders go to sell some of the mortgages they issue to clients. Traditionally, when a bank issued a mortgage they would earn a profit it on if from the stream of weekly or monthly payments made by the homeowner, however, more recently after issuing a mortgage a bank would then go sell that mortgage on the secondary market. The sale of the mortgage on the secondary market meant that the institutions buying the mortgages from the lenders were now entitled to receive the stream of mortgage payments made by the homeowners. This benefited the mortgage lenders because after selling the mortgage on the secondary market, they could then extend a new mortgage to an additional client with the money they received from the sale on the secondary market. In turn, the institutions which purchased the mortgages on the secondary market would bundle them together to create a financial instrument referred to as a mortgage-backed securities. These mortgage-backed securities were then sold to institutions and investors across all areas of the financial system such as to hedge funds, pension funds, and insurance companies. So when the mortgage bubble burst not only did the mortgage lenders experience large losses but so did the numerous entities invested in mortgage-backed securities as these securities dramatically declined in value. From there, the problems continued to spread outward, as banks who were some of the most heavily invested in these securities experienced huge losses and thus were forced to dramatically decrease the issue of new credit, ultimately leading to a freeze of the credit market. With the credit market frozen, individuals, small-businesses, and even large corporations struggled to obtain the credit they required and as such businesses and individuals across all sectors of the economy and all areas of the country were dramatically effected.

Now this is where the mainstream beliefs on the causes of the economic crisis run into severe trouble, because as so many talking heads seem to suggest it was the free market (or areas of the economy most free, because as we showed earlier the US economy has never experienced a free market economy) which led us into this mess. However, in actual fact the mortgage industry which is at the root of the crisis, is nowhere near to being a freely operating economic sector, but instead is one of the most heavily regulated and government influenced areas of the entire economy. While the mortgage industry is not only bombarded with regulations and policies implemented by the political establishment's desire for lower lending standards, the most influential entities in creating the collapse of the mortgage industry were the Federal Reserve Bank, Fannie Mae and Freddie Mac. The Federal Reserve Bank (the Fed) which has a monopoly control on the supply of money (made possible by the government), played possibly the biggest role in the creation of the housing bubble by maintaining interest rates at extremely low levels, thus making credit artificially cheap. A good explanation of the Fed's role in the creation and subsequent collapse of the housing bubble comes from Thomas Woods in his book Meltdown:

"The lowering of the target federal funds rate to 1% in 2003 and 2004 resulted in a dramatic increase in the supply of money. This new money and credit overwhelmingly found its way into the housing market, where artificially lax lending standards made excessive home purchases and speculation in homes seem to many Americans like good financial moves."

The huge influence the Fed's monetary policy on the mortgage sector cannot be overstated as without the maintenance of interest rates below natural free market levels the creation of the housing bubble would not have been possible. The government's influence on the mortgage sector does not end with the Fed, but is increased by the existence of Fannie Mae and Freddie Mac, two massive government sponsored enterprises (GSEs). Freddie and Fannie played a significant role in the housing bubble and subsequent collapse as they are the primary purchaser of mortgages from lenders on the secondary market. The massive purchasing of mortgages on the secondary market by these two GSEs only further enlarged the housing bubble, as when a lender sold a mortgage on the secondary market to Freddie or Fannie, as was mentioned earlier it allowed the lender to divest itself from that mortgage and obtain new funds to then go and issue yet another mortgage. However, the existence of Freddie and Fannie and their ability to buy so many mortgages was only possible because of the special treatment they received from the government which through various tax and regulatory breaks allowed them to divert more resources away from other parts of the economy and into the housing sector then otherwise would have been possible under free market conditions. So as one can see the single area of the economy that had the largest impact on the current crisis, the mortgage industry, was not an area relatively free of intervention and regulation, but instead highly influenced and distorted by the government and the desire of so many politicians to create lax credit conditions and easily obtainable mortgages.

When one examines the current economic crisis in logical manner, and looks at reality instead of distorting reality to fit an ideology, the evidence shows that government intervention was the root cause of the current economic crisis, not free markets. Not only has a free market system never existed in the United States, but the area that had the largest impact on the downturn in the economy, the mortgage industry, experiences more regulation and government intervention then most other sectors. Along with various laws and regulations governing the mortgage industry, three massive government controlled institutions, the Federal Reserve, Fannie Mae and Freddie Mac, distorted free market conditions, and diverted a massive amount of resources away from other areas of the economy into the housing sector resulting in the creation of the housing bubble, subsequent collapse of the bubble, and spread of damage throughout all areas of the economy (as a result of Freddie and Fannie creating and selling mortgage-backed securities). The fact that so many politicians, economists, and other talking heads are calling for more government intervention and a move away from the slight economic freedom that exists in the American economy is a very dangerous proposition. Until more people understand that government intervention is not the answer to what ills the economy, but instead the cause, the prosperity of America will only continue to decline.