It has been common, in recent days, to hear people talk about how the current financial difficulties show the inherent failings of the free market, and provide a clear proof of the need for increased government regulation. Needless to say I’m skeptical.
Take the two most recent and obviously bubbly events. During the 90’s stock prices, particularly tech stocks and particularly particularly dot.com stocks, were massively overvalued. Eventually the bubble popped, stock prices fell, and many firms went out of business. Likewise, starting in the late 90’s and continuing until recently home prices were massively overvalued. We all know what happened next.
Could these bubbles have been prevented by government action? Certainly. The government could have stopped the stock market from going up and it could have stopped housing prices from rising. Perhaps it could even have done so in a way that didn’t impede non-bubbly growth (though I expect that, even with benefit of hindsight, this would have been a tricky business). But whether or not it would have been good for government do this, to think that government would have done so is, I think, the height of naivete. The same forces that lead to the creation of a bubble are going to make any attempt to stop a bubble highly unpopular politically. So even if there was some government regulation that could have prevented the bubble, the very fact that it would have done so makes it highly unlikely such regulation would be implemented before the bubble pops.
Once a bubble has popped, of course, the political will for regulation may be stronger. But that regulation is apt to be unnecessary at best, and will often be counter-productive and pernicious. Unnecessary because the bursting of a bubble in a given area is itself a far greater disincentive to a new bubble in that area than any regulation could be. Just as a person is more likely to lock his doors if he has been robbed or if he sees a spate of robberies in his neighborhood, so people who have lost a lot of money getting involved in a particular “sure thing” investment venture or if he has seen many others do the same. If General Custer had somehow managed to escape from Little Bighorn, no government regulation would have been necessary to keep him from doing the same thing again, only the “natural regulation” of experience.
On the other hand, government regulation in the wake of an economic is as likely as not to be counter-productive and pernicious. If you take the measures the federal government has taken in the wake of the housing bubble, almost none of them are designed to prevent another bubble in the future. In fact, where they do not involve simple rent-seeking, many of the government measures seem designed almost with the hope of reigniting the forces that gave rise to the bubble in the first place. Credit standards were too low and lending engaged in too freely, and the aim of government action has been to keep them from tightening and to encourage more lending. Home prices were too high, and the aim of government action has been to keep them from falling. Low interest rates led to a speculative glut, and the Fed has responded by pushing interest rates back towards zero. Indeed, the whole premise of the Paulson plan was that markets were being overly pessimistic, not that they were liable to irrational exuberance. To trust in government regulators to keep bubbles from happening is, thus, not a terribly wise strategy.
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