What the free market needs

Without the right political, social and moral institutions, it’s just a utopian theory.

October 21, 2008

The free-market system, it is now fashionable to say, is to blame for the current financial crisis. By way of rejoinder, a growing cohort of commentators have argued that the crisis should be understood not as a failure of free-market economic theory but as its vindication. They argue that the U.S. government perverted the wisdom of the market by encouraging banks to make loans no rational actor would make — and that the players took the risks they did because they held a reasonable expectation of a government bailout should things get hairy.

The problem, in this view, is not that the markets were free but that they weren’t free enough.

This analysis happens to be largely correct. Nonetheless, the people who advance it tend to get a particular kind of fish-eyed stare in response. Deep down, they know what that stare means. It’s the very look they themselves used to give the earnest coffeehouse Marxists who argued that the problem with communism wasn’t that the theory was wrong but that it hadn’t been applied properly.

A bit of intellectual honesty is required of free-market economists. Free markets work splendidly, in theory. But as no less a free marketer than the great Adam Smith himself observed in “The Theory of Moral Sentiments” — the book that preceded “The Wealth of Nations” — in application, free markets rely on specific social, moral and political institutions. These institutions must be exceedingly robust if the free market is to deliver on all of the splendid promises made for it.

In most of the world, they are not, and the chances of making them significantly more robust are slim.

Contract law, transparent regulatory structures, transparent bookkeeping and systems for exchanging accurate economic information — such as a free press — are essential if a free market is to work. Very few countries have any of these, much less all of them. Because it relies on such rare conditions, the smoothly functioning free-market economy that never suffers the financial equivalent of an epileptic seizure is in most of the world almost as much of a utopian ideal as the centralized command economy in which there are no lines for bread.

Free-market boundary conditions are complex. They are still poorly understood. The causes of the Wall Street meltdown will no doubt be debated for a good time to come. But clearly a toxic mixture of a lack of transparency, inadequate regulation, inadequate systems for exchanging crucial economic information and outright fraud was involved.

In the end, the institutions that support free markets were more than weak enough in the United States and other developed nations to cause complete, if temporary, free-market failure.

One obstacle towers above all the others when it comes to the free market: flat-out corruption. In the developing world, and to some degree in the developed world, corruption is plain to see and receives too little attention. Corruption frequently leads to a disrespect for private-property rights, a judiciary that doesn’t properly enforce contracts, dubious banking practices and a serious lack of regulatory oversight. All will result in economic failure. The blame for this will be placed on the free market, particularly in popular imagination. But this analysis will lead to precisely the wrong kind of corrective action.

I live in Turkey, where free-market policies conjoined with widespread corruption have led to enormous popular suspicion of free-market economics. Critics here point to Turkey’s staggering income inequality as evidence that the free market is failing to deliver on its promises.

In fact, Turkey does not need more government interference in the marketplace. What it needs is less cronyism, an effective legal system, a trusted judiciary, enforceable contract law, a disinterested civil service, modern bookkeeping, accurate property records, a rational system for tax collection, a successful educational system, clean police, clean politicians, transparent campaign financing, a responsible news media and a widespread sense of civic responsibility. Once those are in place, the free market will work like a champ, just as it will in Bangladesh, Venezuela or, for that matter, the United States. But obviously, no one should hold his breath.

Corruption, in turn, often devolves from economic practices that have long historical antecedents. Take Turkey again. A tradition, dating from the 10th century, of organizing political life around loyalty to the tarikat — a kind of clan — is obviously connected to the massive cronyism and corruption that characterize modern Turkish economic life. You need only look at the disproportionate economic support given by the government to the prime minister’s relatives and friends for evidence of this. (Turkish observers would no doubt reply that a similar point might be made about the bailout of Wall Street, which may or may not be sound policy but is certainly tainted by the appearance of cronyism, given Treasury Secretary Henry M. Paulsen’s long career at Goldman Sachs. They might even be right.)

The institutions on which free markets rely may be excellent things, but to most of the world they are alien, antithetical to local history and, when they are adopted, are often more cosmetic than authentic.

The obstacles to wiping out corruption vary enormously from country to country, from culture to culture. No single approach to removing them could even hope to work. This is a point U.S. policymakers fail chronically to appreciate in their efforts to promote the economic system they have been seeking to export since World War II. But appreciate it they must. Without adequate institutional support, free markets will fail — often — and free-market economics will be blamed, wrongly.

This does not at all mean the theory is valueless and should no longer command our allegiance; even free markets that fail regularly create more wealth and raise general living standards vastly more effectively than do command economies. It is essential, however, and only honest to acknowledge that free markets in and of themselves are not enough.

It is much easier to say “just deregulate everything” than it is to create a culture in which people believe deeply that contracts mean just what they say, business will go to those that offer the best services at the lowest price and the courts will enforce the rules fairly. Unfortunately, without such a culture, deregulation is not apt to have the desired effect, and any belief to the contrary is as utopian and delusional as the belief that the command economy would work to perfection if only it were given a fair try.

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