Is the Free Market System Broken?

Richard Nixon once famously said “We are all Keynesians now.” Within a decade of that comment, Keynesian ideas had become largely discredited. Now, the world is turning left after a long period of embracing free market ideas. Avner Mandelman noted with some indignation on this Leftward lurch:

What did Mr. Obama say? He said he stands with the unions against Wall Street, and vehemently faulted hedge fund bond investors for insisting on their legal rights in a bankruptcy.

I am not sure if you grasp how momentous this is. A U.S. president effectively said the law be damned, the sanctity of commercial contracts be damned, if such constructs cause pain to unions.

Indeed, the Economist recently commented that:

Rather than challenge dirigisme, the British and Americans are busy following it: Gordon Brown is ushering in new financial rules and higher taxes, and Barack Obama is suggesting that America could copy some things from France…

Is America that much a bastion of the free market? Barry Ritholz wryly made these observations about the differences between Europe and the US and asked "Who is the Welfare State":

-Europe has cradle to grave health care plans, generous unemployment benefits, and free or subsidized college costs.

-The US gives away public assets (oil, gas, mineral rights) for pennies on the dollar, has huge subsidies and tax breaks, and bails out reckless speculators.

Is the free market system, as it’s set up, broken? Tyler Durden over at Zero Hedge claims to have found an article by Deepak Moorjani, formerly of Deutsche Bank, on the socialization of risk:

Our asymmetric incentive structure is fundamental to our problems. The question remains: Do we maintain the status quo and naively hope for better results, or do we begin to implement structural reforms in order to align the incentives? If taxpayers are forced to pay for the losses from bad trades, this socialization of risk adds to the moral hazard problem. This socialization of risk actually encourages more aggressive behavior in the future.

The call-option bonus structure has led to the ascendency of sales over risk management. Maintaining the status quo is not a smart bet, and we cannot afford to ignore the fundamental issues of structure and compensation.

I have written before on how to fix the asymmetry problem – bring back the partnership investment bank. Meanwhile, nothing changes on Wall Street. Paul Krugman recently commented:

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The Times has described as a “Wall Street éminence grise”? He briefly made the news in March when he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very different from its recent past, declaring, “I am far from convinced there was something inherently wrong with the system.”

For too long, the Right hid behind the principles of the free market when it was to their advantage and now the chickens have come home to roost. This wave of socialization will pass in time. In the meantime, please stand and join in a singing of Internationale.

Comments

[Jasper M:]

In answer to the title, -
We won't know until we really Try it, now, will we?

May 11 05:27 AM

[Tom Armistead:]

The author is talking about free market capitalism. What we have been doing in this country is jungle-ethics financialism.

When financialism sets in, financial instruments become progressively further removed from their role in supporting commerce in the real world and develop a life of their own, a weird shadow dimension, a hall of mirrors, a distorted alternate reality that intersects and reacts with the real economy in unpredictable and destructive ways. George Soros described this phenomenon as “reflexivity.” Derivatives have a lot to do with it. Leverage and the abuse of easy credit are contributing causes. Ultimately, the effect is a bloated bloodsucker that feeds off the real economy until terminal weakness and paralysis set in.

Jungle ethics needs to be distinguished from the free-market concept necessary to the proper functioning of the capitalist paradigm. A system which exalts the most capable financial predator as its highest member will suffer periodic booms and busts – the prey, honest people who work and save and try to invest, become too few and too weak to sustain the predators above them on the feeding chain.

Regulatory reform, if properly done, will restore free market capitalism by establishing some minimum level of ethics and fair play and by outlawing financial insturments and transactions that are not supportive of growth in the real economy.

May 11 06:03 AM

[CautiousInv...:]

Interesting and thought provoking article.

Unbridled democratic capitalism, to the extent it existed, has a new face. And it's a work in progress with the end form difficult to grasp.

What we have observed thus far is an unprecedented willingness to use Treasury funds to, more or less, pick winners and losers with the financial oligarchy a clear winner; a willingness to socialize risk and expose the taxpayer to massive losses with little upside; and use the executive office as a bully pulpit to impose a desired business/social outcomes while ignoring property rights and casually abrogating contractual rights.

This will not be without consequences and, clearly, one consequence is that the cost of capital will increase as investors will need to price in a risk premium for potential government interference in the operation of "open" markets. Along with the prospect of higher taxes, both a consequence and a cost, this will raise the required rate of return before proceeding with an investment.

However a policy initiative is seen and graded, it will have consequences.

May 11 06:45 AM

[notsosmart:]

there was never a free market system.some free-er than othersthats all. these crooks & scoundrels have warped the best system but it was far from perfect. instead of better or free-er the greed & lying & ponzi/casino have made it worse.its still going on & it will continue.sadly.

May 11 08:31 AM

[fireball:]

it is basically everything contrary to the constitution. there are no guards against what tom armistesd calls jungle-market capitalism and there is socialist interference where govt. is supposed to be restrained.
what we end up with is corporate fascism where politicians support thir political donations and the legal bribery of lobbyists. on the other end they give lagesse to secure votes from the sheeple.

May 11 08:37 AM

[nukldrager:]

Excellent comment! If taken to it's conclusion the bloated bloodsucker eventually starves to death as it's food supply runs out in jungle-ethics financialism. And, we don't have capitalists,
we have financilaists. That's a good term, and a good distinction to make.


On May 11 06:03 AM Tom Armistead wrote:

> The author is talking about free market capitalism. What we have
> been doing in this country is jungle-ethics financialism.
> ...
> restore... some minimum level of ethics and fair play and by
> outlawing financial insturments and transactions that are not supportive
> of growth in the real economy.

May 11 08:40 AM

[gdclarke:]

Tom A. has it right "jungle-ethics financialism". Economist Simon Johnson of MIT and formerly IMF puts it very well in this article ...

www.theatlantic.com/do...

May 11 09:25 AM

[The Aft Deck:]

Everyone likes to consider western countries the worlds "free market" when in fact by definition they are not, they are a mixture tending towards socialism. A free market would not provide social security, or many of the other benefits the western society has, jungle-ethics financialism way well be correct.

The "free market" really only exists now in the 3rd world, and despite the many in the west who mourn the death of the free market, it is not in fact what they want.

Western Economies have become reactionary socialists rushing to solve what ever financial or social problem dominates the days headlines.

Within days of the financial crisis, politicians paraded a solution, WAMU as an example was seized and sold in a day.

How many of us in all seriousness could go to work tomorrow morning, negotiate, pen and execute the sale of our business before 5pm?

I am beginning to question if any real thought of the ramifications of the various bail-outs has been considered.

May 11 09:40 AM

[Bull Run:]

Adam Smith would never have imagined how his theory of capitalism would have been transformed in America. America's middle class was the world's envy for decades, holding vast sums of wealth,never seen before in history. Farmers, iron worker, auto workers,even government workers, were able to send their children to college, have a second home, 2 cars, exotoc holidays, NO other nation had this wealth that was spread over such a large percent of the population. Since the mid 70's this all changed.The transfer of wealth from hard working Americans to Wall Street. In the last decade 41% of all domestic profits, came from Wall Street, (hedge funds, investment banks, NY financials). These profits would then be funneled into 2% of the population.Not Adam Smiths vision. NO more middle class, that is the envy of the world. America's middle class has become similar to Europes "working class".The transfer of wealth has what has destroyed America. This was accomplished by the means of "scams". It started when Wall Street realizied in the mid 70's that growth was diminishing, Wall Street needed to make investment vehicles. The 1st was the S&L loan scams, government backed, next the junk bond craze, then the dot com scams, and turning the NASDAQ into a venture exchange, then the sub prime loan and CDO's and CDS's scams. Don't get me wrong I believe in a good scam. as well as the next person, but they're all the same.. Wall Street takes something of NO value, Junk bond, sub prime morgage, and sells it to someone with NO money, unquiified home onwer.. It is Now classified as a morgage or bond, so it can be wrapped up into a "investment plan" and slid out the back door into Grama's retirement package. The transfer of wealth is complete, Wall Street has the money and the middle class is left with the "plan". America's distortion of capitalism fed by greed, is the ruination of America.

May 11 09:40 AM

[Ferdinand E...:]

"A US president effectively said that the law be damned." I have a problem believing that. Having gone to engineering school on the south side of Chicago, I cannot imagine any intelligent man, of any race, creed, color or background, who lived in that part of the world, expressing contempt for the law.

And by the way, when President Obama said that the US should copy a few things from France, what he probably meant was the 'new-old' light cuisine.

May 11 09:48 AM

[E Nuff Sed:]

I'd prefer the welfare of my fellow citizens anytime over the welfare of Wall Street. If that makes me a socialist then so be it.

May 11 09:54 AM

[Rob Viglione:]

Todays' economic ills are not the result of free markets. So much of our economy has been distorted and politicized for decades that to call FNM, FRE, the Fed, Congressional edits, and thus far ~ $11T in deficit spending (fiscal stimulus?) attributable to free markets is nuts.

If anything, the debilitated state in which we now find our economy is evidence that government intervention and political economics do, indeed, have long term consequences.

It is a shame that the public's memory is so limited, and the economy so complex, that it is not easy to attribute direct consequence to each public policy. Too many politicians and bureaucrats get away without blame for decades of bad legislation and social engineering gone bad.

May 11 11:53 AM

[tonym:]

Absolutely 100% dead one comments; government intervention is the reason the free market is struggling.

On May 11 11:53 AM Rob Viglione wrote:

> Todays' economic ills are not the result of free markets. So much
> of our economy has been distorted and politicized for decades that
> to call FNM, FRE, the Fed, Congressional edits, and thus far ~ $11T
> in deficit spending (fiscal stimulus?) attributable to free markets
> is nuts.
>
> If anything, the debilitated state in which we now find our economy
> is evidence that government intervention and political economics
> do, indeed, have long term consequences.
>
> It is a shame that the public's memory is so limited, and the economy
> so complex, that it is not easy to attribute direct consequence to
> each public policy. Too many politicians and bureaucrats get away
> without blame for decades of bad legislation and social engineering
> gone bad.

May 11 06:10 PM

[dragonpaw:]

I'm voting on the comments and my votes are not giving me correct before and after counts. How Orwellian is this?! I will not continue to respond to these "Alpha" articles until this discrepancy is corrected. Mostly very insightful and blilliant comments.

May 11 09:04 PM

[THofler:]

Amen Rob.

In 2003 a Fannie mortgage had a minimum down payment of 2%; which means the homeowner is levered 50-to-1. Fannie itself was levered 60-to-1 approximately. Freddie & FHA were similar & trillions of government mandated loans were made.

We could blather about the rest of it, but the economy could never have survived this shot to the heart.

May 11 09:58 PM

[axelrod608:]

More partisan political bull manure. that'll fix the economy. Perhaps you didn't notice when the previous President shredded the Constitution. The right wing attack machine is full speed ahead. screw economics. Let's just find someone to blame. That'll fix everything, right ??

I can't believe SA runs this drivel.

May 11 10:50 PM

[dragonpaw:]

Dear Mr. Armistead;
Jungle- ethics financialism is truly more polititcally correct than "unfettered conspiratorial pathologic greed." Free markets have little to do with as this form of greed as it plays out. It follows the path not unlike that of "tulipmania" in the late fifteen hundreds in Europe. (Wikipedia has a good synopsis of this phenomenon.) Markets in free-fall are more akin to chaos theory than economic theory. Few economists seem to want to dabble in "chaos" theory. Perhaps too much like a dose of reality?
Quoting George Soros on his theory of ''reflexivity" is like having Alan Greenspan extoll the virtues of derivatives before they brought the market to ruins. Greenspan at least has the excuse of having lived in a ivory tower full of fawning sycophants. Age and shrinking mental capacity also buy him some pathos.
Soros represents an ongoing and expanding breed of would -be world -wide money manupilators. His dog-and-pony TV appearances full of "we (meaning all theUS)did this wrong, and we did that wrong," are simply a smoke-screen that he is schilling for his billionaire buddies to "reconfigure" global currency markets into their back pockets.
Free markets exist only at the "micro-" level. As long as Wall Street,
insurance/broker/banks and poloticos are in charge, all "macro-" markets will continue to be closed, conspiratorial and manipulated. I see nothing on the horizon to change this. He--! , I don't even hear this discussed anywhere. Anybody else thinking something like this??

May 12 04:20 PM

[Clive Corcoran:]

A stimulating article with some good comments - the socialization of risk - if it becomes embedded in the US system which is becoming increasingly likely it would be a game changer. The asymmetry is the large scale problem but it is the elimination of the proper cost/benefit framework of how markets allocate that would be the main victim
Bull Run's comments are a pretty good summary of what went wrong with US capitalism - and yet many of them happened as a result of the championing of the Wall Street culture as the last great frontier of rugged individualistic free enterprise.
Economies prosper through creating value not by transferring it from one group of "smart" traders to other groups of "less smart" traders. For an entire economy market timing is not a viable business model.

May 15 01:27 AM