The myth of the free market

Yesterday, we marked the one-year anniversary of the collapse of Lehman Brothers, a day that has become known as the “day that changed American capitalism.” On that day, two of the country’s largest investment banks—Lehman Brothers and Merrill Lynch—disappeared, the world’s largest insurance company—AIG—imploded, and Wall Street’s surviving financial institutions were forced to accept massive infusions of government capital in order to forestall a similar fate. In the year that followed, pundits have constantly opined about “America’s shaken faith in the capitalist system.” At Columbia, Spectator opinion columnists Kate Redburn and Sarah Leonard boldly announced, “Never have conservatives’ odes to market forces seemed more delusional than now, as the market’s unregulated force sweeps the country into a historic recession.” These kinds of statements serve as damning assessments of free market ideology and its consequences. If only they were true.

In reality, the factors that contributed to the financial crisis were far more complex and varied than a simple overzealous adherence to free market principles. If we take a serious look at how the American economy functions—especially the housing market—true economic freedom becomes difficult to find.

In order to understand why the collapse of the housing market had such devastating effects on the American economy, we first need to understand real estate’s important place in the economic system. Houses are the largest assets and account for most of the net worth of the vast majority of American families. As a result, price increases in the housing market can lead to substantial economic growth. In the aftermath of Sept. 11, the Federal Reserve was desperate to kick-start the economy and understood the potential impact that a strong housing market could have on America’s short-term economic performance. In order to achieve this goal, the Fed had to stimulate demand, and the best way to do so was to keep interest rates low, which would, in turn, make mortgages cheaper. So, for almost three years, the Fed kept its benchmark rate below 2 percent, which was extremely low by historical standards—this ignited the housing market.

At this point, we need to take a step back and ask ourselves if the massive bubble in housing prices was caused by an unchecked free market or by a government policy blunder. If we think of the housing market under noninterventionist circumstances as a simple campfire, rising and falling moderately in accordance with natural changes in the environment, the Fed’s decision to cut interest rates so dramatically was the equivalent of pouring in gasoline, causing the fire to explode and burn down the entire forest. The move to cut interest rates was taken by a government body under political pressure to get the economy out of a recession quickly before the 2004 election. Moreover, anyone who is knowledgeable about the crisis will tell you that the housing bubble was the cause of our problems today. Thus, having just illustrated that the massive appreciation in prices was directly caused by the Fed’s interest rate policy, it becomes increasingly difficult to blame a nonexistent free market for our current troubles.

To be fair, the Fed’s decision to lower interest rates is only a part of the story, albeit a large part. Subprime mortgages were what ultimately killed Lehman and AIG and served as the immediate instigator of the crisis of 2008. Although most people use the logic that a lack of government regulation led to the development of these instruments, that view is woefully shortsighted. One of the fundamental principles of economics is that people respond to incentives, and the Fed-induced housing bubble created a massive incentive for banks and mortgage lenders to create exotic securities backed by bad loans. Wall Street saw a tremendous appreciation in housing prices and therefore crafted financial instruments to profit from the situation. Yes, the banks were myopic and failed to recognize the systemic risks posed by their actions, but those actions would have never occurred had it not been for government intervention in the housing market.

The point that I am trying to make is not that we should abolish the Fed, go back to the gold standard, and live in some anarcho-capitalist society with no government. Rather, my argument is that the seeds of the financial crisis were sown by a government-induced housing bubble, and to blame the situation on the free market is to miss the point entirely. Laissez-faire capitalism has become vilified by people who are trying to push a political agenda, and oftentimes, they simply don’t understand what they’re talking about. If America comes out of this crisis thinking only that the free market needs to be “regulated,” then we are destined to be not just a nation of low growth and diminished opportunity, but one that is only a single policy blunder away from yet another economic catastrophe.

Jon Hollander is a Columbia College senior majoring in economics. He is the director of intergroup affairs for the Columbia University College Republicans. Reasonably Right runs alternate Wednesdays. opinion@columbiaspectator.com