Why Markets Fail

Ben Shapiro

11/4/2009 12:01:00 AM - Ben Shapiro

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.

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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?

They fell for it because they assumed that the federal government would prevent fraud. They fell for it for the same reason that Bernie Madoff's investors fell for his scam -- the U.S. Securities and Exchange Commission is supposed to prevent these sorts of things. We pay our taxes so that a government agency will do our research for us and ensure that sales pitches are proper and accurate. We do not want to abide by the age-old aphorism "caveat emptor" -- buyer beware. We do not want to be self-informed buyers. We want to be spoon-fed information by our investment advisers, no matter how ridiculous the information.

The only problem is that the federal government has proved itself utterly incapable of preventing fraud. Instead, the federal government provides the illusion of security to buyers while allowing sellers to do anything until proven guilty in a court of law.

The easy solution would be to reinvigorate a healthy sense of self-reliance in investors and buyers -- tell Americans to do their own research, to do business with those they trust.

President Obama's solution is to create more regulations -- regulations that will undoubtedly be ignored by bad actors and that will undoubtedly hamper honest businessmen. On Tuesday, the Huffington Post reported that the House is considering legislation, backed by Obama, that would allow the Federal Deposit Insurance Corp. (FDIC) to interfere in private derivatives contracts in cases of emergency. In short, if a company like Goldman Sachs were to buy a derivative from Morgan Stanley, and Morgan Stanley were to go under, the government could stop Goldman Sachs from collecting the derivative.

In theory, this sounds great. In practice, it creates an incentive for Morgan Stanley to sell too many risky securities. Then, if Morgan Stanley fails, the federal government would allow Morgan Stanley to skate on its financial obligations.

This all sounds far more complicated than it actually is. The bottom line is this: When the government assures market actors that they do not have to live up to their obligations -- basic obligations like research or paying their obligations -- the market collapses. That is not a failure of the free market. It is a failure of a government-perverted free market. Financial thieves are the same as all other thieves: they do not respect the law. More financial laws will not make financial liars more honest any more than gun laws prevent criminals from acquiring firearms. In fact, more financial regulations will only provide market participants the same false sense of security that brought about the current crisis.