(AP)

If you think the world has had a free-market financial system, think again. A free market avoids the distortions due to regulation; buyers and sellers drive the outcomes; competition is rigorous, and can produce volatile results; there is free entry and exit; investors are free to take risks, harvest any gains and bear any losses.

The free market in finance in the US ended in 1912 with the legislation to create the Federal Reserve System, the central bank. Before that, financial crises were simply Darwinian: panicked depositors; numerous bank failures; economic contractions; no management of the economic cycle or monetary policy; no safety nets for consumers; no government bailouts. Depositors usually responded with panic, creating bank-runs that destabilised institutions and the entire financial system. In The Panic of 1907, Sean Carr and I detailed the last unregulated banking panic in the US. In many cities, banks issued certificates instead of gold, equal to about 14 per cent of all the currency with the public. Banks suspended withdrawals by depositors; this triggered a national wave of hoarding cash. About 20 per cent of all the cash was simply withdrawn from the US financial system.

(Pic By Ian Bradshaw)

To be sure, the financial markets in some countries are comparatively more free than others — certainly much more free than those in North Korea and Cuba, for instance. Some sectors of financial services are more free than others — think of hedge funds and private equity funds. And as the shareholders of Northern Rock, Lehman Brothers and Bear Stearns have been reminded, the system is free enough to let them absorb some stunning losses. But make no mistake, governments are involved cheek-by-jowl in the functioning of financial markets.

I am not arguing that this is as it should be. We should not endorse government regulation carelessly. First, regulators can become captive to the very industries they regulate. Second, the private sector tends to squirm away from regulators. Make a rule, and executives and their lawyers will find exceptions and/or a way to skirt it. Third, private markets innovate relentlessly. This means that, like the general who always prepares to fight the last war, regulators tend to manage the private sector the way it used to be, not the way it is or will become. Fourth, it is all too easy to forget the costs of regulation. Government coffers are easy targets for special interest groups seeking to save certain firms, jobs and industries. With the bailout of the US banks, you can be sure the auto and air transport industries will be close behind seeking a safety net. Risk-reduction afforded by regulation is not costless. Do we want an absolutely risk-free society? Absolute risk reduction would choke off innovation, entrepreneurship and growth. Think of the Soviet Union, circa 1989. To be sure, where human safety is at issue, we want no doubts.

I think we do need government intervention in the financial services industry because the costs of coordination are too great, and the consequences of failure are too high. The current crisis is distinguished from previous crises by very great complexity, high speed of news and cash, and very large scale. It is hard to imagine the wreckage that would have occurred by now without the government’s interventions to date.

Against this backdrop, the regulatory innovations roiling the markets do not strike me as the death knell of comparatively free-market capitalism. Or at least, if there is a death to grieve, then it must have happened a long time ago. Let the pundits mourn; it sells copy. Taxpayers will be mourning for quite some time, although for a different reason.

The author is Dean, Darden Graduate Business School, University of Virginia

(Businessworld Issue 14-20 Oct 2008)