Free Markets vs. Efficient Markets: Free People vs. ‘Equal’ People

Many broad explanations have been offered for the economic collapse of 2008, including corporate greed, government incompetence and personal irresponsibility. Specific causes have also been put forward, for example: Fannie and Freddie bankrolled insolvent mortgages; unsound derivative investments toppled the mortgage industry in particular and the credit markets in general; aggressive promotion of the Community Reinvestment Act encouraged unwarranted borrowing by persons incapable of repayment; or artificially low interest rates fueled unsustainable borrowing. A novel thesis that in some sense incorporates both general and specific explanations for the crash has been put forth in a new book Panic: The Betrayal of Capitalism by Wall Street and Washington by Andrew Redleaf and Richard Vigilante. Broadly stated, the authors’ explanation asserts that those responsible for our economy (the business community that creates it, the government that regulates it and the consumers and investors who sustain it) all abandoned free markets in favor of efficient markets. The book explains why the folly of replacing the unpredictable, turmoil-filled and at times chaotic environment of free markets by the supposed safety, predictability and manageability of ‘efficient markets’ was both the proximate and ultimate cause of the crash.

The context of the book is almost exclusively economic, to some extent social, and nearly completely apolitical. In this article I will identify five main themes in the book, all of which are socio-economic. I will show how each has a political analog and that the consequences of the pursuit of these analogs (which has occurred) has been just as devastating to our polity as the pursuit of the authors’ five was to our economy.

Replacing free markets by efficient markets. Redleaf and Vigilante contend that our financial gurus, having grown weary of the unpredictable nature of free markets, developed a new system of rational or efficient markets. There are many components to this system change but the main principle can be summarized in the following quote from the book’s dust jacket:

‘This ‘ideology of modern finance’ replaced the capitalist’s appreciation for free markets as a context for human creativity with the worship of efficient markets as substitutes for that creativity. The capitalist understands free markets as an arena for the contending judgments of free men. The ideologues of modern finance dreamed of efficient markets as a replacement for that judgment and almost a replacement for the men.

Under the influence of contemporary financial theory, bankers and regulators abandoned basic tools of financial analysis and judgment for elaborate, statistically based insurance schemes and a blind faith in the efficiency of modern securities markets.

The result: it became impossible for either executives or regulators to fully understand the financial condition of any great modern bank. Believing that financial systems could transcend the need for human judgment the bankers and regulators combined to create financial institutions with balance sheets no one could judge.’

The main thrust of the book is an explanation of why this strategy backfired.

Now politically, the United States has made an equivalent swap. We have traded the fundamental principle of a free people for that of ‘equal’ people; that is, the ultimate goal of liberty in American society has been superseded by the drive for equality. Allowing the people to freely pursue their dreams under the rubric of God-given rights, which grant them the liberty to chase those dreams – as long as they don’t impede similar pursuits by their neighbors, often leads to messy and unpredictable outcomes. Those who would alter the system to have government decide which dreams are compatible with the ‘greatest good’ for society, who shall pursue which and how they should be pursued, those people believe deeply that such a ‘progressive’ system would result in a fairer, more equitable, orderly and just society.

Redleaf and Vigilante show how the abandonment of free markets for efficient markets led to arrogance concerning our ability to tame market forces and the unintended consequence of financial structures for which we were totally unable to value their worth. In the same way, our surrender of liberty for equality has resulted in a society in which we are unable to distinguish good from evil, morally appropriate behavior from degeneracy, knowledge from trivia, justice from perversion or tradition from fad.

Replace entrepreneurs by experts. Free markets are driven by entrepreneurs – those whose vision and drive are so powerful that they are motivated to found businesses, develop new industries and raise capital in order to produce new products. The problem is that, although such drive frequently leads to innovation and prosperity, more often than not the entrepreneur’s vision is misdirected. Too many mistakes are made and too many people get hurt in the process. Therefore, progressives conclude, we should rely on government bureaucrats working in tandem with industrial experts to chart our course through the shoals of free enterprise in order to lead us to the safer waters of a managed economy.

Redleaf and Vigilante refute this conclusion by showing that ‘experts’ are no more adept at picking economic winners and losers than are private entrepreneurs. Moreover, since neither the sweat of their brow nor the green of their wallet is invested in the enterprise, bureaucrats and experts are far more likely to fail than is the entrepreneur at identifying a priori the most profitable business ventures and products.

Politically, the country is making the exact same philosophical mistake. Instead of entrusting the key decisions of our social, cultural and political lives to the ones closet to the action – parents, relatives, clergy, civic leaders, we have surrendered the authority to structure our lives to distant government regulators, judges, bureaucrats and other ‘experts’ who micromanage – and mismanage – our schools, communities, farms, factories, laboratories and our nation as a whole. Instead of trusting our instincts, traditions and experience, we rely on government’s big brothers to decide for us how to live our lives. As in the economy, individual initiative is stifled in favor of government-inspired uniformity and predictability.

Replace morals by systems. Redleaf and Vigilante explain how the success of business correlates positively with the morals of the people involved – including producers, laborers and consumers. In picking winners and losers, the market relies on the good sense of millions of individuals who make choices in the complicated processes of starting and managing a business, marketing and distributing its products and of course also in the evaluation and purchase (or not) of said products. Success or failure is governed by people’s sense of what is the value to them, their families and communities, and to the nation in general. Since producers must satisfy their customers in order for their business to succeed, excellent morals among the latter guarantees that the former will behave scrupulously. But, say progressives, morals are judgmental. So, as the authors explain, we replaced them with systems. The objective is to scientifically design processes and mechanisms, grounded in logic and dispassionate evaluation, which would maximize the chance of success of new products. Of course, it does not work. The systems developed on Wall Street and in Washington were opaque, needlessly complicated and flawed in design. Can you say Fannie and Freddie, Lehman Brothers or AIG?

Once again, the same type of flawed substitution manifests itself in the socio-political milieu. We replace a reliance on the good moral behavior of the people by a reliance on multiculturalism, tolerance, non-judgmental attitudes and diversity. What a fool’s quest! The effect has been to replace the shared values of our traditional culture – i.e., a Calvinist work ethic, rugged individualism, American exceptionalism, Judeo-Christian Western Civilization, and a devotion to free markets, limited government and individual liberty – by a falsely uniform soup of mushy ideals that no one except diehard progressives believes in. We have diluted the character of the American people and separated ourselves from our history, traditions and our national purpose.

Eliminate risk. Free market capitalism is inherently risky – very risky. Historically, Americans were prepared to incur the risks for the promise of success and prosperity. Individuals might suffer, but on average the population grows richer. However, in recent decades, our society in general and our financial moguls in particular became increasingly risk averse. New systems (see the previous item) accommodated that sea change. But of course, it did not work. Some risks were averted, but the system did not anticipate other risks caused by the irresponsible promotion of the Community Reinvestment Act, corruption and duplicity at Fannie and Freddie, and artificially low interest rates. These were sufficient to bring down the house of cards.

The desire to eliminate risk is even more prevalent in our culture and politics than in our economy. We want the government to insure our health, our houses, our businesses, our credit arrangements, not to mention our bank accounts. The government can only do so by putting us in the straight jacket of high taxes, excessive regulation, bloated spending and oppressive nanny state rules. We have traded freedom for security and in the end we obtained neither.

Capitalism without capitalists. Redleaf and Vigilante again:

Capitalists are owners. Capitalism rests on strong ownership. Being an owner means more than having the right to the income from an asset. Ownership implies both the legal right and the practical capacity to make judgments about the care and use of the asset. Judgment and ownership are inseparable. Both the mortgage crisis and the crash are best understood as the result of government policies that pushed trillions of dollars in assets out of the hands of relatively strong owners and into the hands of weak owners….

The driving force behind this massive shift from strong ownership to weak ownership was the ideology of modern finance. Replacing the notion of free markets as an essential context for capitalist creativity was the worship of supposedly efficient markets as substitutes for capitalists themselves.’

In a parallel fashion, we increasingly have a ‘free country’ without free people. We pay lip service to our founding documents and we take pride in calling ourselves ‘the land of the free.’ But we surrender more and more of our freedoms to a coercive Federal Government in exchange for security and an oppressive equality of outcome. We mistakenly declare our economic system to be capitalistic whereas in fact it is at best a mixed free market/managed economy that is dangerously close to being a Euro-style social welfare state. Similarly, we declare ourselves to be a Constitutional Republic of limited government, federalism and individual liberty whereas we have evolved into a soft tyranny managed by a central government of elites and false experts.

In 2008 the US experienced a severe economic crisis caused by a change in our fundamental economic axioms. We have also altered our basic political axioms in an essential way. It is therefore likely that a severe political crisis lies in our near future.
This article also appeared in The Intellectual Conservative at: