Is a free market "free" if it's regulated?

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"Greed, for lack of a better word, is good": the immortal words of corporate raider Gordon Gecko, a character in Oliver Stone's 1987 film, "Wall Street." Gecko continues in his speech to shareholders, "Greed clarifies, cuts through, and captures the essence of the evolutionary spirit" [source: IMDb]. Greed also forms the basis of capitalism. And capitalism is founded on a free market.

Greed is another word for the economics term rational maximization. This is the (supposedly innate) desire to get as much for oneself as possible. Theoretically, this makes sense; we humans desire to ensure our survival. But in practice, the idea that all humans rationally maximize doesn't always stand up (see What's the ultimatum game?).

This, in part, explains why there is a long-standing debate over just how freely a free market should be allowed to operate. That debate heated up in the United States in 2008 as the federal government took control of financially crumbling mortgage holders Fannie Mae and Freddie Mac. The move wasn't essentially dramatic; Fannie Mae and Freddie Mac, though privately operated, were chartered by Congress (Fannie Mae was chartered during the Great Depression). But the takeover prompted fears of a nationalization of the U.S. economy.

Nationalization occurs when full or partial control is taken of private financial institutions, usually to avert a crisis. Scandinavian nations successfully averted an economic meltdown through nationalization in the early 1990s, and in 2007 and 2008, the federal government of the United States took similar actions. The Federal Reserve Bank oversaw the buyout of investment bank Bear Stearns by rival JPMorgan, guaranteeing $30 billion in Stearn's bad debt and even bending to shareholders who forced a higher price per share during the buyout. Even more pronounced, the government took a 79.9 percent stake in private insurance company AIG in return for an $85 billion investment to save the company.

Under pure capitalist theory, none of these actions should've been taken; the government should have stood by idly while the economy tanked. So how can a free market be "free" if it's regulated?

 

The Pros and Cons of a Free Market

Well-diversified British bank HSBC posted a profit increase during the 2008 economic crisis. Should it survive the recession, HSBC will have proven itself an asset to the market. See more recession pictures.
Matt Cardy/Getty Images

Essentially, capitalism is a free market system of trade, governed exclusively on the economic principle of supply and demand and maintained through competition. Consumers and businesses form a relationship that ultimately determines the cost of a good or service and the health of the market. If demand is up and supply can adequately satisfy it, then the market is strong. Lots of people have money to buy new things, more new things are produced and sold, and wealth is generated. This wealth is then dispersed throughout the society, all strata of which ultimately benefit: Companies require labor in boom times, thus increasing employment; taxes paid on that wealth end up funding government social programs for the poor.

If a market hits a bump in the road -- for example, through a stock market crash or a housing slump -- demand decreases. Less wealth is generated, employment decreases and ultimately, the poorer classes suffer most. This is the stickiest aspect of capitalism; it's highly Darwinian in nature. Companies unfit to operate (and inherently taxing to the capitalist system) won't weather an economic downturn. Those that can make it through a recession -- which is simply a decline in economic progress -- have ultimately proven that they're an asset to the economy.

This is how the market corrects itself. A recession strips away bad assets, whether in the form of a poorly designed security or a badly managed business. Those remaining should be strong enough to rebuild the market. After a recession ends, the process will begin again.

So it's natural that capitalism fosters competition. In "The Wealth of Nations," economist Adam Smith, regarded as the father of capitalist theory, laid out how capitalism inherently protects members of a society. When supply outpaces demand, companies compete to offer the lowest price to consumers, who benefit from the competition [source: Smith].

The father of capitalism, 18th-century Scottish political economist Adam Smith The father of capitalism, 18th-century Scottish political economist Adam Smith
The father of capitalism, 18th-century Scottish political economist Adam Smith
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But a competitive marketplace also encourages companies to do everything in their power to maximize profits. Companies seek to achieve monopolies -- sole control of a good or service, wherein prices are set by the company rather than market demands. Wages are set as low as laborers will tolerate. Steps to ensure consumer protections such as safety and quality should be taken only insofar as they attract a customer base. Capitalism itself is often criticized as an amoral system, since it prizes the self above others [source: Greider].

Smith pointed to built-in checks and balances of the capitalist system that are meant to prevent abuse. For example, higher wages mean a laborer can afford to properly feed himself or herself. In Smith's words, "[a] plentiful subsistence increases the bodily strength of the laborer" [source: Smith]. So a company that pays more than average wages will create a stronger workforce and increase its productivity, giving it a competitive edge in the marketplace.

When Smith's capitalist theory was put into practice in the nascent United States, these natural checks and balances didn't always emerge. As a result, the federal government has enacted forced checks and balances to counteract the weight produced by unfettered competition. What has emerged is a hybridized version of a free market. ­

Does the United States Have a Free Market?

Violent strikes, like this one in Passaic, New Jersey, in 1926, led to new federal labor laws. Depending on your view, the government either protected American workers or leveraged unrest to gain control over business.
Violent strikes, like this one in Passaic, New Jersey, in 1926, led to new federal labor laws. Depending on your view, the government either protected American workers or leveraged unrest to gain control over business.
Topical Press Agency/Getty Images

One of the tenets of capitalism is that a free market fails from time to time. The market should be able to correct itself by ridding itself of the poorly performing businesses and investments that dragged it down. But the United States has a long shown a lack of faith in the free market's natural correction mechanism.

In times of financial crisis, the United States has customarily turned to capitalism's antithesis -- socialism -- to artificially correct the markets. The very existence of the Securities and Exchange Commission (SEC) alone indicates the U.S. economy isn't a free market. For the first 116 years after it was established in 1817, the New York Stock Exchange operated without government regulation. Following the crash on Oct. 24, 1929, the federal government held hearings that revealed the types of fraud corporations used to mislead and swindle investors. These hearings led to unprecedented government oversight of the stock market. For one, corporations now had to file earnings reports with the newly formed SEC, which had the ability to audit these companies [source: Berenson].

But the SEC's formation in 1934 was hardly the U.S. government's first foray into business. By the end of the 19th century, the government concluded that major corporations such as Standard Oil, Carnegie Steel and Union Pacific Railroad had grown too powerful. As a result, a spate of laws and bureaucracies were created to offset this power. The Sherman Antitrust Act of 1890 outlawed monopolies. The Food and Drug Administration was created in 1904 and vested with litigation of companies that broke new purity laws. The Federal Trade Commission was created in 1914 to regulate competition among American companies. The Fair Labor Standards Act of 1938 established a national minimum wage for workers (25 cents an hour) [source: Dept. of Labor]. Under a pure capitalist system, none of these laws or entities should exist.

­­Essentially, each act limited markets by granting the federal government the power to regulate business. As a result, the United States no longer has a free market system. Instead, the United States now has a managed economy -- by definition, a nonmarket economy since it doesn't exist solely on supply and demand [source: Merriam-Webster].

These government regulations are constant -- even in periods of calm and prosperity. But they tend to emerge during times of crisis; the market crisis of 2008 is a good example of a managed economy in action. In addition to the interventions already mentioned -- like the takeover of Mae and Mac and the buy-in of AIG -- the U.S. government also called for further steps to artificially correct the market. In September, a $700 billion bailout was proposed. In the wording of the plan, the government would take unprecedented control of the market. Not only would it intervene by purchasing businesses, it would also temporarily nationalize some of them and control how they're governed. One provision stipulates how much compensation these companies can offer their executives after the government purchases their bad debt [source: U.S. House].

Whether it's favorable that the United States has a managed economy instead of a free or socialized one is purely academic. It would literally take a revolution to steer a government toward either pole of the economic spectrum. Unlike corporations, governments can exercise their will virtually unfettered. If a government decides to intervene in a market, there's little anyone -- capitalist or socialist -- can do.

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Sources

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