Many believe that the housing boom and Great Recession were the result of human greed and the supposed deregulation of financial markets, both of which thereby demonstrate the failure of free market capitalism. However, the real causes of the boom and bust are to be found not in free markets, but in the misguided policies of politicians and central bankers. We should not compound the errors of the boom by thinking more government intervention is the cure. The economy can only be fixed by the decentralised reallocation of resources by millions of entrepreneurs in genuinely free markets, and not by the politicians who broke it in the first place.

It was the Federal Reserve System’s decision to drive interest rates very low in the mid-2000s and the US government’s attempt to expand home ownership, especially through the government-sponsored enterprises (GSE) Fannie Mae and Freddie Mac, that artificially drove up housing prices. That bubble became the foundation for a whole set of financial instruments predicated on that price bubble. When housing prices fell, the value of those instruments did as well, devastating bank balance sheets and precipitating the financial crisis.

It was these interventions, not free markets, that caused the Great Recession. One implication is that it was during the boom of the last decade that we made the mistakes from which we are now trying to recover. The recession and recovery are the economy attempting to shed capital and labour from where it is no longer profitable and then figuring out where it would be better used.  This process takes time, which is why recessions have unemployment and slow growth.

Boosting aggregate measures of consumption and investment through government stimulus will not help, as the problem lies not in macroeconomic aggregates but in the microeconomic allocation of resources. Only those located in the context of the market have the knowledge and the feedback processes provided by prices and profits to make the decisions that will reallocate resources as quickly and effectively as possible. The decentralised decision-making and learning processes of the free market, and not more of the government intervention that caused the problems, can accomplish the millions of corrections are needed to get resources where they belong and return to a sustainable pattern of high employment and growth.

Read Steve Horwitz’s paper here.

1 thought on “What government broke, government cannot fix”

  1. Posted 25/07/2012 at 16:13 | Permalink

    Wonderful as normal, keep up the good work!

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