The world needs free financial markets

Many have argued that this is a crisis of the free market economy, with many arguing that the liberalisation moves of the last 25 years be rolled back and that governments become more interventionist.

Indeed, sales of books by Karl Marx are said to be up by several hundred per cent in Europe - one of the few items that increasing in sales these days - and governments are taking over one financial institution after another.

But this is not a crisis of the free market. Neither is it reason enough to reverse reforms that have increased economic freedom in recent years.

First of all, there will always be economic downturns. But tough as they may be as they happen, they are a small price to pay for the long-term prosperity increases. In western Europe, average real GDP per person is at least 14 times higher than it was in 1820.

In fact, the last 25 years of increased economic freedom have also been a golden age globally, especially the last decade. Global growth rates have never been as high – or reduction in extreme poverty as rapid. Freer financial markets were essential in this development.

Second, the crisis was to a large extent created by government, not markets. The US government used both monetary and fiscal policy to create the housing bubble. And what was created by government intervention, surely, may not be solved by more of it.

The US government's role

Free markets are characterised by creative destruction: Old products, companies and jobs are replaced by new and better ones. Without government intervention in the US financial markets, the decline would have been more limited and the market actors borne the loss.

How did the US government create the core of the crisis? First it did so when the US Federal Reserve lowered its interest rate to one percent between 2001 and 2003, fuelling the housing bubble. Second, it did so through various interventions in the mortgage market.

The Community Reinvestment Act fuelled bad risks in the credit market. Public authorities evaluate the number of branch offices of banks in low-income areas and how many loans are granted there. If these are considered to be too few, banks run the risk of being sanctioned, via fines for instance.

Then we have the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation - Fannie Mae and Freddie Mac - two financial institutions founded by the US government subsequently sold to private owners but still receiving subsidies and agencies for politicians.

Governments should not be players

In short, sympathetic political aims of increasing home ownership among low-income households and minorities led to massive lending to people who could not pay: All in all $1300 billion in 2007.

As the downturn came, people could not pay, which everyone knew from the start. And then markets re-packaged the loans, which resulted in many more financial institutions were involved in bad credits.

So markets had a role. But if there had not been a great amount of government-created loans to re-package, the problem would have been smaller. The US government took a huge risk with all the tax-payer's money. Possibly a greater risk than any private player in the market would have taken.

There are definitely those in the financial markets who have made the wrong decisions. But the crisis would not have been of such magnitude had the government not played its main role. For all those now asking for more government, that is worth remembering.

Governments had to jump in with bail-outs to solve an emergency that they had partly created, but after the bail-outs, there have to be pull-outs. There is a need for sound and transparent regulation, but governments should set the rules, not be players. And tax-payers must get their money back.

What is wrong with foreign owners?

We urgently need to resist pressure for governments to stay involved in the financial sector – and even more important, to resist protectionist tendencies. The disasters of the 1930s were to a large extent produced by that kind of reaction to the crisis.

The proposal by French President Nicolas Sarkozy to create European Wealth Funds is just such a protectionist measure. What is wrong with foreign owners? Why should European countries compete in socialising their own companies? In the light of the role of Chinese wealth funds in fuelling the US bubble, surely that is another government intervention we could do without.

Governments need to keep focussed on necessary long term free-market reforms, not only crisis management. And they need to resist pressures to subsidise every industry – from shipyards to car makers – now that the financial sector gets a bailout. The financial sector is the heart of the economy, which makes it a special case.

If we subsidise every industry, deficits will soar and old jobs and products will remain – for a while. But we need to maintain change and progress in the economy. And that can only come from a free-market economy.

The author is a research director with the European Enterprise Institute, a pro-free-market think-tank, and co-author of the new policy paper The Financial Crisis – a Gigantic Politics Failure (EEI)