Free markets — not so free after all

A long time ago in a distant galaxy —1962 in Sydney, Australia, to be exact — an economics professor assigned an essay on whether the period between 1830 and 1870 was appropriately named the period of laissez faire in Europe.

I argued that though economists and some politicians argued for laissez faire policies during that period, and they were tried for brief periods in a few countries, laissez faire economics was never really implemented.

I received the top grade (for the first and last time in my career at Sydney University.)

This early episode in my academic career was brought to mind by a recent essay by Paul Kasriel, director of economic research at Northern Trust Corp. of Chicago. He wrote that while some pundits and politicians are concluding that the economic and financial challenges of the last year are the result of the failure of free markets, he would respond that free markets haven’t been tried.

For example, Mr. Kasriel pointed to the market for credit.

“We do not have free markets in credit in the U.S., or anywhere else that I know of,” he wrote.

“The price of short-term credit is fixed by central banks … It is beyond me why most economists would view with horror some government agency fixing the price of say, copper, but view the fixing of the price of short-term credit by central banks as nothing to be alarmed at,” Mr. Kasriel wrote.

He wrote that by holding a key short-term interest rate below or above the unobservable free-market equilibrium rate, the central bank either creates credit or destroys credit, “which leads to distortions in the economy and financial markets.”

Mr. Kasriel argued in his essay that “we are now experiencing the economic and financial fallout from [former Federal Reserve Board Chairman Alan] Greenspan’s interference with the free market,” because Mr. Greenspan kept the federal funds rate far below its equilibrium level.

Mr. Kasriel noted that Mr. Greenspan interfered with the free markets when some risk takers (e.g., the now-defunct Long-Term Capital Management of Greenwich, Conn.) erred in their estimation of risk, and stepped in to cushion their losses by slashing the federal funds rate.

Regulators also have interfered in the credit markets, Mr. Kasriel wrote. Companies, municipalities and governments that want to tap the U.S. credit markets need credit ratings and fiduciary institutions are required by law to invest only in “investment grade” instruments.

In addition, the Securities and Exchange Commission designates which rating agencies may be used to verify the creditworthiness of securities, so there is no free market in approved credit rating agencies.

Finally, there is the case of Fannie Mae of Washington and Freddie Mac of McLean, Va. — hybrid financial institutions that had, until recently, an implicit federal guarantee, and now have an explicit one.

Because they are publicly traded companies, Mr. Kasriel wrote, their shareholders wanted their managements to maximize shareholder value. “This meant that Fannie and Freddie were incented to take on extreme leverage — because they could — as a result of their debt being implicitly guaranteed,” he wrote.

But for their hybrid status, and the implicit guarantee, they couldn’t have taken on so much leverage, Mr. Kasriel wrote, “and this means that taxpayers would not now be picking up the tab … So we do not know definitively whether free markets have failed because we have not had free markets. And given that the response to recent events is, and will be, increased regulation and continued Federal Reserve intervention in the markets for credit, we will be moving even further away from free markets.”

Of course, Mr. Kasriel’s argument, though valid, won’t stop politicians from adding more regulation, as he fears, and probably doing more damage in the long term.

Related Topics: At Large