The Wisconsin Policy Research Institute

In Defense of the Free Market

By Benjamin Artz

In troubling times, people generally feel the need to appeal to a higher authority for help, guidance and support. Students ask their teachers for mercy when they fail an exam. Children often ask their parents for assistance when they make mistakes. In the same way, America is turning to its parent, the government, for the help it needs to get out of this mess. America needs new guidelines and rules to abide by in order to stay out of trouble. After all, rules are essential to grow healthy and responsible children as well as economies. But too many rules can stunt the growth of a free market economy. All the free market needs is a little guidance and it will still be the best way to allocate resources.

The free market, unhindered by government intervention in most cases, is still the best way to organize production and trade resources. In free markets buyers and sellers interact with each other, efficiently exchanging information about the value of resources to each other. In this way goods and services are sold to those who value them the most while being produced by firms that can do so in the most efficient way. This all depends though on the free exchange of all information regarding the transaction. If all parties are not privy to the same information, the transaction can break down and suspend trust between buyers and sellers. This is exactly what happened in the financial sector.

In a way, banks and institutional funds around the world were able to buy into the “booming” real estate market in America through the creative use of credit default swaps. When banks loan to individuals they accept a certain amount of risk. Through credit default swaps (CDS) they are able to insure against default by paying another institution to accept the risk. The insuring institution can then enter into a CDS contract with another insurer and leverage its position, effectively earning a profit on an asset it does not even own. This exchange would not be a problem if the institutions were fully aware of all parties involved as well as the inherent risk associated with CDS contracts. Unfortunately this was not the case. Each CDS was a private transaction rather than one made in an open market, preventing institutions from the ability to price into each transaction each asset’s true risk. As a result the CDS market ballooned to roughly ten times the size of the actual asset values. Of course when the loans went into default the CDS contracts imploded and created a serious case of distrust in the sector, leading to where we are now.

This is where the government intends to ride in on its white horse to rescue us from certain oblivion. But we do not need that. All the financial sector needs is information. Even now a clearing house for credit default swaps is being discussed. A simple legislation to treat the CDS like an insurance contract would help as well. We need to gain a fuller understanding of the financial sector and build transparency in the information available behind all financial products. We do not need a large-scale government umbrella filled with growth-stifling regulations.

As of yet the world has not discovered a better way to organize economic activity. The free market, without too much government intervention, is still the best we can do. After all, economies do all of the growing on their own. Governments should only act to guide them, not repress them.

-October 3, 2008

In Defense of the Free Market

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