IS THIS the end of American capitalism? As financial panic spread across the globe and governments scrambled to contain the damage, reality seemed to announce the doom of U.S.-style free markets and President Bush's ideology. But this is wrong in two ways. The deregulation of U.S. financial markets did not reflect only the narrow ideology of a particular party or administration. And the problem with the U.S. economy, more than lack of regulation, has been government's failure to control systemic risks that government itself helped to create. We are not witnessing a crisis of the free market but a crisis of distorted markets.
It's true that the Bush administration has stood for light regulation of capital markets. But it did not invent this approach. By the middle of the last decade, experts across the spectrum believed that U.S. financial institutions faced outmoded restraints on their ability to innovate. Thus, the Clinton administration, supported by then-Federal Reserve Chairman Alan Greenspan, refused to tighten regulations on financial derivatives, memorably dubbed "financial weapons of mass destruction" by Warren Buffett. The 1999 repeal of the Glass-Steagall Act, a Depression-era law separating commercial banking and investment banking, passed with overwhelming bipartisan support in Congress and was signed into law by President Bill Clinton.
We'll never know how this newly liberated financial sector might have performed on a playing field designed by Adam Smith. That's because government interventions of all kinds, from the defense budget to farm supports, shaped the business environment. No subsidy would prove more fateful than the massive federal commitment to residential real estate -- from the mortgage interest tax deduction to Fannie Mae and Freddie Mac to the Federal Reserve's low interest rates under Mr. Greenspan. Unregulated derivatives known as credit-default swaps did accentuate the boom in mortgage-based investments, by allowing investors to transfer risk rather than setting aside cash reserves. But government helped make mortgages a purportedly sure thing in the first place. Home prices seemed to stand on a solid floor built by Washington.
Government support for housing was well-intentioned: Homeownership is a worthy goal. But when government favors a particular economic activity, however validly, it must seek countervailing control to ensure the sustainable use of public resources. This is why banks must meet capital requirements in return for federal deposit insurance. Congress did not apply this sound principle to Fannie Mae and Freddie Mac; they were allowed to engage in profitable but increasingly risky activities with an implicit government guarantee. The result was that taxpayers had to assume more than $5 trillion of their obligations. Contrast U.S. experience with that of Canada, where there is no mortgage interest deduction and the law requires insurance on any mortgage over 80 percent of a home's purchase price. Delinquency rates at Canada's seven largest banks are near historic lows.
The new capitalist model that emerges from this crisis must operate according to more consistent principles. The Fed should set interest rates with the long-run value of the dollar in mind. Government must be more selective about manipulating markets; over the long term, business works best when it is subject to market discipline alone. In those cases -- and there will and should be some -- in which government intervenes on behalf of social goals, its support must be counterbalanced with taxpayer protections and regulation. Government-sponsored, upside-only capitalism is the kind that's in crisis today, and we say: Good riddance.