The financial sector is in crisis. Lehman Brothers has collapsed, Merrill Lynch sold, Fannie Mae and Freddie Mac nationalised, and AIG looks like it may well go the same way. In the face of such market turmoil, it is to be expected that the old doomsayers are out in force, bemoaning the folly of the free market, and wallowing in the glories of nationalisation as our collective saviour. But such joy is misplaced. The free market is still only partial, and indeed too young to be blamed for the current economic woes.
To use an analogy, imagine that person A and person B have been given a chain saw. Person A has been given an instruction book, reads it, and follows it to the letter. As such they immediately and quickly get started trimming a few bushes.
Person B, on the other hand, has not been given an instruction book. Instead he must work out how to use the chain saw for himself. Because he is an intelligent person (and can learn from the work performed by A) B quickly works out how to use the chain saw. However, because B does not have an instruction book, he is quite happy to cut everything in site, while A checks each section to ensure that he does not attempt to cut something that is too thick for the chain saw.
Very quickly, B is able to take over A, and produces, because he is not stopping and starting, produces a cleaner and more even cut. Unfortunately, B is suddenly stopped in his tracks when he tries to cut something too thick. The chain saw jams; indeed, the chain saw backfires and B loses his grip. B is shaken for a few minutes, but he quickly recovers and starts again. This time he avoids the thick branch.
Soon, A and B find a poll in the bush made of a material neither has come across before. A can find no reference to the poll in his instructions. As such, both A and B decide to try and cut it. They both fail and the chain saws backfire. Afterwards, A is given a new instruction book, listing iron poles as another thing that the chain saw cannot cut through. B is not given any regulation.
Later, A and B come across a pole made of another material neither have come across. With his new instructions, A is told not to cut through anything that he does not recognise. As such, he does not cut it. In contrast, B tries to cut the pole and finds that it is made of rubber and cuts easily. He can then continue, ending up with a clean shaven bush with only a couple of thick branches and iron poles protruding.
What this is trying to show is that a regulated market is retrospective. With deregulation, banks have been able to make investments they have never been able to try before. Some of these investments, like the metal pole, have proved to be bad. But it is only after the investment was tried that this proved to be the case. As such, the free market has also learnt the lesson.
Nevertheless, some investments, like the graphite pole, were successful. In an ever changing world where regulations are often years behind progress, such investments would not have been realised had it not been for the free market.
Undoubtedly, the current economic crisis derives from banks lending to people who cannot pay them back. The fall-out from this has meant that the liquidity upon which banks depend has contracted. But what should be emphasised is that the free market can now learn from this mistake. As such, person B will not try and cut the thick branch with the chain saw again.
A deregulated market is in its infancy, and people are still learning how to use the freedom it affords. To finish with a final analogy, a child who has been playing virtual rugby for years is finally allowed to play it for real. During his first match he breaks his leg, and mother prevents him from ever playing again. So, he returns to his virtual game. Just imagine the opportunities lost by that child had he been able to learn rugby properly, especially now that he is an overweight couch potato in front of a television screen.