Laissez-Faire is Dead, Again

The Fed's recent aid to the financial sector - expanding "discount window" lending to investment banks and arranging (and providing a dowry for) the marriage of Bear Stearns and JP Morgan - has led to growing recognition of the limits of "free market" dogma and the need for regulation of the financial sector. Financial Times columnist Martin Wolf says:

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

The Wall Street Journal's David Wessel writes:

[S]omething big just happened. It happened without an explicit vote by Congress. And, though the Treasury hasn't cut any checks for housing or Wall Street rescues, billions of dollars of taxpayer money were put at risk. A Republican administration, not eager to be viewed as the second coming of the Hoover administration, showed it no longer believes the market can sort out the mess.

Although the acceptance that unregulated markets and laissez-faire do not automatically lead to the best of all possible worlds may represent a swing of the ideological pendulum, this isn't exactly new. In recent years some have tended to forget, or ignore, what has been long understood: financial markets are characterized by market failures (e.g., asymmetric information) and prone to crises. Therefore, some government intervention is merited.

What we are seeing today is a re-cognition, indeed. Brad deLong explains using the example of British Prime Minister Robert Peel, who understood this in the first half of the 19th century. For a more philosophical view, Mark Thoma usefully points us to "The End of Laissez-Faire," a 1926 essay by John Maynard Keynes tracing the history of laissez-faire dogma, and the role of economists in perpetuating it. Keynes explains that laissez-faire is often misperceived as an implication of economics: "the guarded and undogmatic attitude of the best economists has not prevailed against the general opinion that an individualistic laissez-faire is both what they ought to teach and what in fact they do teach."