Free Market Ideology Melts Down

The near collapse of the world banking system and the internationally coordinated government rescue should put to end illusions about the unfettered market. Over the last three decades there has been an enormous upward redistribution of income in the United States and many other countries. This redistribution was justified as being the result of the efficient working of the free market. After this massive government intervention to rescue the banks from their own actions, such claims are no longer plausible.

The financial sector stands out as being both at the center of free market ideology as well as the leading engine of inequality in the economy. The United States has substantially deregulated its financial industry in the last three decades. It eliminated barriers that prevented firms from crossing traditional boundaries between areas like investment and commercial banking or banking and insurance. It also eased restrictions on leverage and relied to a substantial degree on self-regulation.

This environment proved to be very profitable for the financial industry. Its share of corporate profits soared, crossing 30 percent at its peak in 2004. High level executives in the sector were extraordinarily well-paid, with salaries and bonuses often running into the tens of millions of dollars, even for those who were still a level or two below the top of the corporate hierarchy.

These high salaries set a benchmark for top executives in other industries. Wall Street pay scales even infected pay structures outside of the corporate world, leading to outsized paychecks for top officers in universities, hospitals and even private charities. With more money going to the top, there was less for those at the middle and bottom. Over the last three decades, the real wage of a typical worker in the United States has barely increased.

This upward redistribution could possibly be justified if it were the result of the natural workings of the market. However, the events of the last few weeks show that this was not the case. Essentially, the financial industry was making huge bets, not with its own money but essentially with the government’s money.

As long as the industry won their bets, they could pretend that they were acting on their own and had no need of the government. However, when they lost big, as they did with the collapse of the housing bubble, they had no choice but to go running to the government for help. Wall Street executives, who might complain about a government support check of a few thousand dollars for an unemployed single mother, suddenly were demanding hundreds of billions of dollars from the government to keep their banks from collapsing.

There are two obvious lessons from this episode. The first is that the enormous wealth that many top executives in the financial sector were able to accumulate had less to do with their mastery of finance than their ability to get into positions where they could extract rents from the economy. These people clearly did not understand the enormous costs that their risky investments and mistakes have imposed on the economy and society.

The second lesson is that a strong role for the government is essential in the shaping of markets. The key assumption behind deregulation was that sophisticated actors in the financial sector would effectively police each other, punishing firms that did not follow sound lending practices.

It turns out that many of the most sophisticated actors had no understanding of what was going on in either the industry or the economy. The collapse of the housing bubble and the over-leveraged state of the major financial firms caught the industry by complete surprise.

Going forward, it is clear that far more careful regulation will be needed. Governments will have to act to ensure that banks do not again become highly leveraged and assume such enormous levels of risk. Central banks will also be required to view asset bubbles as a serious problem. The growth and subsequent collapse of the housing bubble is at the core of this crisis.

Finally, this crisis should cause people to discard the idea that the distribution of income is ever determined by the natural workings of the market. It is determined first and foremost by the structure of social institutions. In the United States, these structures were deliberately shaped in a way to cause income to flow upward. There is no reason that the institutional structures cannot be designed to lead to more broadly based prosperity, which is likely also to result in far better economic outcomes.