President Obama says he is a fan of the free market. Back in September, Obama spoke to Wall Street. He stated, "I have always been a strong believer in the power of the free market." He then explained that he wanted common-sense regulation of the market: "Common-sense rules of the road don't hinder the market, they make the market stronger. Indeed, they are essential to ensuring that our markets function fairly and freely."
To paraphrase Spanish dueler Inigo Montoya from "The Princess Bride": President Obama, you keep using the phrase "free markets." I do not think it means what you think it means.
Here is how the free market works: open competition among sellers, informed bidding among buyers. Sellers are responsible for competing; buyers are responsible for informing themselves. When the government pledges to increase competition or keep buyers informed, the market is no longer free. And when the government makes those pledges and then fails to enforce them, the free market is utterly perverted.
Unfortunately, President Obama's favorite "common-sense" regulations attack both sides of the free market: they restrict competition among sellers while providing false guarantees to buyers. They require that sellers charge certain prices or meet certain conditions, and they incentivize buyers not to do their research -- after all, the government will ensure that no one puts bad products into the market place, right?
Wrong. Goldman Sachs is a perfect example of how the quasi-free market championed by Obama leads to chaos. On Monday, McClatchy Newspapers reported that Goldman Sachs, the nation's leading investment bank, profited handsomely from the downturn in the housing market by falsely selling mortgage-backed securities as triple-A rated investments. The securities were actually closer to junk. In 2006 and 2007, Goldman sold more than $40 billion in mortgage-backed securities, meanwhile betting against the housing market in shady ways.
The question isn't whether Goldman committed legal fraud here, although the indicators say that Goldman did. The real question is why buyers would buy these securities? The wizards of finance who bought the mortgage-backed securities while listening to Goldman's triple-A sales line must have been willfully blind -- many of these securities were backed by immensely hazardous subprime mortgages. So why did the buyers fall for it?