I have noticed that capitalism often takes the blame for regulatory schemes gone wrong. I can understand why politicians would want this outcome, as regulation increases their powers, while deregulation limits their sphere of influence. What puzzles me is why so many simply accept the self-serving arguments of the regulators.

Let me give three examples.

First, the California energy crisis is often described as a failure of deregulation, and is used as an argument for the necessity of regulation in the energy sector. However, California was hardly deregulated. Some aspects of the industry had regulations loosened or removed, but many aspects remained strongly regulated. The contracts for purchasing bulk energy, for example, were still heavily regulated. So it is wrong to say the California market was anywhere close to a free market in energy.

But, let us concede the point and pretend the market was completely deregulated. We still have a problem trying to blame this one on capitalism. For example, one of the biggest problems faced by the California energy providers was an inability to come up with enough power to meet consumer demands. Why? Well, primarily because California has prevented the building of any new generator capacity. This is not the fault of capitalism, but of regulation.

Of course, if this had been a fully free market system, excepting the restrictions on building, the providers could have gone out of state for power. Here we run into those few remaining regulations, which made the purchase of additional power unprofitable. There were also a number of long term contracts drawn up under regulation which were no longer profitable when the industry was deregulated, which made the purchase of energy a losing proposition for the industry. None of which are the fault of deregulation.

In short, California had problems because the state refused to allow anyone to build new power plants. They then imposed rules on the purchase of energy that made bringing in energy from outside sources unprofitable. These were both the fault of regulation, not a free market.

For our second example, let us look at the Savings and Loan industry. Some at the time claimed that "deregulation" was what caused the collapse and subsequent bailout.  However, this ignores two major factors that were not free market, but the remnants of regulation. The S&Ls were destroyed because of the FSLIC safety net and the portfolios forced on them by earlier regulations.

Let us deal with the portfolios first. The original concept of the S&L was that they would be primarily a vehicle for providing long term mortgage lending. The portfolios forced (or encouraged) on the S&Ls during the regulated days were filled with long-term, low interest loans, mostly mortgages. Even after deregulation, these portfolios were largely unchanged, as the S&Ls had a hard time unloading a lot of large, low interest pre-Carter loans. This meant the S&Ls had a problem generating liquidity when a crisis struck.

And the other factor was certain to make a crisis strike. When the S&Ls were "deregulated" the government forgot to remove the FSLIC. So, the government basically said "We are not restricting your investment behavior any longer, but if you lose too much, we will cover your losses." In other words, the S&Ls were gambling with other people's money. Under a free market, the owners, shareholders, or partners would be liable for losses, and would therefore be somewhat careful. When they were guaranteed by the FSLIC, it gave them less incentive to exercise caution*.

Again, we have a crisis where the effects of past regulation and the remnants of regulation after supposed "deregulation" are to blame, yet the free market gets accused of causing the problem.

Finally, we can look at the pre-Federal Reserve bank crises. Several times recently, I have seen people respond to criticism of the Federal Reserve by saying "So there were no crashes or bank runs before 1914?"  Which is a silly argument for many reasons. First, no one is saying that the banking system would be perfect under a free market, simply that it would avoid most of the problems of a fiat currency. Second, and more importantly, the US had very few periods during which the banking system could be called free. Between the Civil War and the establishment of the Federal Reserve we had various systems, but all of them were characterized by state or federal involvement and a policy of pyramiding many multiples of currency on top of reserves. That is, before the Fed we may have had a specie based system, but it was still heavily regulated and designed to exert inflationary pressures. So, to blame the failings of that system on the free market is also a mistake.

None of this is meant to imply that the free market will be a panacea. The free market suffers periodic adjustments. Individuals, or whole sectors of industry, can suffer setbacks, or disappear altogether. The free market offers no guarantees.

But neither do any of the other systems. They may pretend that regulation protects people from the unpredictable free market, but they do not. Regulation simply creates new and worse problems elsewhere. Or maybe they simply delay a problem and make it worse. Whatever they do, they do not overcome the laws of economics. Any adjustment that would occur in the free market will eventually take place in a regulated market as well. The difference is the regulated market will do additional harm along the way.

No, the free market does not promise success or perfection, but what it does offer is very important. The free market offers the fastest and most accurate response to economic pressures of any economic scheme. Every system will eventually respond to economic pressures, the free market just does it more quickly, gets us past the harm the quickest, allowing us to move on.
Other systems attempt to defer these adjustments, but that just increases costs, exacerbates the problem, and eventually leads to even greater suffering.

Let us look at one example, money supply deflation**.

If we had a fully free banking system, it is unlikely we would have a universal excessive expansion of credit, mroe likely it would be limited to a single bank, but, for purposes of our argument, let us assume that every banker went mad at once in the same way and expanded credit too far. How would the free market react? Bankers, seeing the imbalance, would try to call in short term loans, to decrease credit available, they would increase interest rates to deter additional expansions of credit,and generally exert deflationary pressures. Those bankers who failed to do so would be seen as having too risky a policy, they would see larger accounts fleeing their bank, and would probably feel pressure form shareholders to follow the herd.

The economy as a whole would suffer a short term slowdown. Borrowing and new building would slow, consumer credit would tighten, and then, after a time, things would return to normal with a smaller money supply.

What changes if we add in the Federal Reserve? In the best case, they would do what our bankers did. So, in the best case, the Federal Reserve is useless, as it just mimics what a free market would do. But let us suppose they decided to try to "help" us and "soften" the slowdown. The only way to do that would be to farther inflate the money supply, exacerbating the problem. Or, I suppose, they could try to deflate at a rate much slower than our free market bankers. (The free market bankers would have to deflate relatively rapidly to remain as soluble as their competitors, but as there is no competition with the Fed, they can do things at whatever pace they choose.) But deflating more slowly does not really put off the suffering, instead it extends it. As they slowly tick up interest over time, investors come to expect it, and the impact is the same as if they did it all at once, except that it takes much longer. As investor expectations heavily influence the markets, it really does no good to do things in tiny steps, as a series of small steps leads investors and others to expect that trend to continue.

And there is one other consideration when speaking of the Federal Reserve we don't have when speaking of bankers. Despite all the supposed safeguards, the Fed is susceptible to political pressure. Remember that added inflation I mentioned above as a nonsensical move, because it would just make the problem worse? Why did I even mention it? It is obviously the worst idea from a economic perspective, but from a political perspective, it is the most likely.

Which means that, while the free market would see a brief deflationary period with some discomfort, the Federal Reserve would most likely continue to inflate the money supply until inflationary pressures either forced a dramatic, and much more painful, deflation, or the market simply crashed under its own weight and brought a full scale recession. In other words, what would be a minor annoyance for the free market, dealt with in passing, would most likely expand into a full blown crisis under a regulated system.

Some will accuse me of being unfair by brining in political considerations, but I think not. Any regulation is of necessity political. If you were going to obey purely economic concerns, you would have left the free market alone. Once you start to tinker with the markets, you are short circuiting economic signals, and the only other basis for decisions is political. So, political concerns are not tangential to regulation, they are at the very heart of regulatory agencies. Thus, it is hardly unfair to bring in political concerns.

Well, this has dragged on much longer than I intended. I started out simply wanting to point out how many people blamed capitalism unfairly, and I ended up ranting about the Federal Reserve.

I suppose I should cut it short here, saying in parting that, when you hear someone ranting about the flaws of capitalism, be sure that what they are describing is really a capitalist system and not simply some mis-named regulation.

------------------------------------------------------------

* I know there is some contention over what caused the S&L crisis,  and even I admit that more than government safety net and poor portfolio composition went into it. I also understand that the FSLIC did not completely cover all funds, my description is a bit over-simplified. However, my point is still the same, there was a lot of regulation remaining, as well as the legacy of past regulation in both portfolio choices and business practices. So, to blame capitalism is just absurd.

** Again, this is excessively simple. Bit as it would be almost impossible for all banks in a free system to over-inflate credit all at once, I had to make some allowances. Also,l do you really want to read fifty pages of caveats, or one or two over-simplified paragraphs? I know I left out a number of factors and ignored a lot of economic pressures. If you want a very detailed post, tell me so in the comments. If enough boring technocrat types coming by demanding I delve into the minutiae of credit expansion and monetary theory, then I will post one just for them.

--------------------------------------

NOTE: To avoid any confusion, let me say I use both "the free market" and "capitalism" here to indicate a fully laissez faire economic system. I assume that the only economic function of the government is to provide civil courts to settle disputes and criminal courts and police to prosecute theft and fraud. Beyond that everything is handled privately via contract. (Whenever the subject of capitalism comes up, the various rather loose definitions of that term tend to create a lot of disagreements born of nothing more than mismatched definitions. So I am providing a very clear definition here.)

One more note here, under a true free market, nothing like our current bankruptcy laws would exist. They would be more akin to the bankruptcy laws Scotland once had, where some protection was provided for the debtor, but he was still obligated to repay the full amount of each debt. (This is important when reading my comments on the S&L crisis, as assuming the free market would have something like our current bankruptcy laws would make my argument weaker.)