4 Myths About Free Markets—and Their Demise

Would the free market do it better?

That's one big sticking point for legislators opposed to a huge bailout bill to get the financial system back on track. Before the failure of President Bush's first $700 bailout bill on Monday, a memo urged 100 or so conservative Republicans to call for a "free-market alternative to the Treasury Department's proposal." Republican Rep. Mike Pence of Indiana, who voted against the bill, explains on his website that "renewing our belief in the power of the free market must be our guide" to a better solution.

Free markets sure sound good—after all, what's not to like, if they're "free"? But the pure and airy version of free markets that keeps showing up in speeches doesn't really resemble the way free markets work in reality. A few of the prevailing myths about free markets:

They're fair. The idea that supply and demand always achieve equilibrium, that sellers always find buyers, and that every good has a price makes it sound as if pure free-market mechanisms ensure fairness and decency. Not really. In true free markets, there are winners and losers, and the losers lose hard. The most efficient and ruthless companies drive others out of business. There's no guarantee of competition, and monopolies form. Prices rise. And the powerful tend to get more powerful. Consumers take what they can get.

They're unregulated. In theory, the less government regulation, the freer the market. But the economy we're used to has multiple layers of regulation that have formed over decades, with general approval from most corners of society. Teddy Roosevelt interfered in free markets by helping break up mammoth monopolies in the oil, railroad, and banking industries—to great popular appeal. After the Depression, we got bank deposit insurance and dozens of other free-market intrusions that most people still favor. The "free market" of just one year ago—before anybody was talking about a bailout—featured all manner of government intervention, from unemployment insurance to federal car-safety standards to an activist Federal Reserve able to pull various levers to keep the economy humming. So when people invoke the power of the free market, which free market are they talking about? The one of 150 years ago, with very few consumer protections? Or the one of a year ago, already heavily regulated?

They're efficient. When it comes to investing capital and running a business, yeah, it's likely that a company operating in accordance with the profit motive will spend its resources more wisely than a government bureaucracy answerable to politicians. But when problems develop across the whole system, markets tend to seize up. That's because all the players who behave rationally when protecting their own interests don't necessarily agree what's best for the whole system. In the current crisis, for instance, banks with money to lend are sitting on it instead, fearful that borrowers might default. And so far, no market mechanism has persuaded banks to start lending again for the good of the overall economy. Market solutions usually do emerge, but it can be bloody and destructive getting there, because every participant fights to get as much as it can for itself. For well over a century, the appeal of government intervention has been the feds' ability to act as a mediator seeking the best solution for everybody, instead of simply letting various interests fight to the death.

They're cheap. Would a market solution to the financial crisis cost less than the $700 billion proposed in the failed bailout plan? If we truly had a free market, almost certainly not. Most economists agree that a pure market solution would allow hundreds of companies to fail, with no safety net for the suddenly unemployed, bank depositors, creditors, or anybody else brought down by widespread economic failure. That would probably kick off a second Great Depression, which is why there are virtually no free marketeers arguing that we should repeal layers of existing regulation and return to a truly unregulated market. Plus, with less regulation, there's a lot less for Congress to do.