When the history of this crisis is written, it could be a story of the death of market liberalism and the ascent of market socialism. Yet the truth is that the source of the crisis was not private free markets, but markets tainted by mistaken government policies designed to satisfy special interest groups.
U.S. monetary policy was too loose for too long, an error Alan Greenspan has still not admitted; government privileges bestowed on Fannie Mae and Freddie Mac, especially the implicit (now explicit) guarantee backing their debt, politicized the flow of capital, increased risk‐taking and fueled overinvestment in the housing sector; and rating agencies and regulators who were supposed to monitor risk‐taking were asleep at the wheel.
Markets require an institutional framework in which private property rights are well‐defined and risk is clearly assigned. The purpose of regulation should be to ensure that those who take risks bear the full cost of them and can capture the full reward from them. Competition is the best device to discipline private traders and investors. Often, however, regulation reduces or outlaws competition and imposes rules thwarting market forces and individual responsibility.
Government failure, not market failure, would be a more accurate description of the subprime/credit crisis. There would have been less risk‐taking and more market discipline if Congress had not guaranteed Fannie and Freddie debt and had not passed the Community Reinvestment Act, which pressured banks to promote subprime and Alt‐A mortgages. Moreover, by holding the Federal funds target rate at 1 percent from July 2003 to June 2004, the Fed fueled the housing boom.
With the large bailouts now occurring, the mistakes made in underpricing risk and overextending credit will be felt by present and future taxpayers. The socialization of risk and the privatization of profits is always a recipe for disaster. It undermines the rule of law and economic freedom by weakening private property rights. When investors believe government will bail them out, they increase their risk‐taking and leverage, just as Bear Stearns and other large investment banks did. And when foreign central banks know that the U.S. Treasury stands behind the debt of government‐sponsored mortgage lenders, there will be an artificially large market for their securities.