Free Markets

I heard the following idealized description of how and why a truly free market can work. For purposes of this example, the term free market simply means a market where no regulations are present or required. Similar to, for example, the Credit Default Swap market that’s been identified as a contributing factor to the financial crisis the major world markets are currently experiencing.

Ok, so here’s the example. Let’s say you have two kids, both of whom like chocolate bars. And you have one chocolate bar. To be fair, each child should get half of the chocolate bar. And because this is a “free market”, you can’t have a third party (e.g. the government) divide the chocolate bar in half. The two kids need to do it themselves.

How do you accomplish this?

You do this by telling the children that one of them is allowed to divide the chocolate bar in half, but the other gets to choose which piece he or she wants.

Sounds pretty cool, doesn’t it? Isn’t this a great, if highly simplified, example of how a true free market can operate without regulation?

Well, no, it isn’t.

Here’s the problem as I see it. If the rule is that one child gets to divide the chocolate bar and the other gets to pick which half they want, and no one is there to oversee the process, what happens if the bigger, stronger kid decides he or she wants the entire bar all to themselves? What’s the other kid going to do about it? There’s no one to enforce the one rule that exists.

That’s the problem with a truly free market. If there aren’t some minimum regulations that are also enforced, then there are always going to be people who cheat the market and get away with it.

As game theory predicts, this can’t go on indefinitely because cheaters will eventually be identified and will be shut out of the market. So a particular player in the market probably can’t keep cheating and continue to get away with it. But as we’ve seen in real life, it can continue on long enough that it can lead to disastrous consequences. This is what has happened to us. A bunch of people saw an opportunity to “cheat” in the mortgage and related markets, and they got away with it — for a time. But now they’ve been found out and the markets are correcting, albeit at a cost of trillions of dollars.

This is why markets need some amount of regulation that is both enforceable and enforced. And why, when we overturn laws such as the Glass-Steagall Act and allow (essentially) unregulated (and largely un-understood) markets such the Credit Default Swap market to exist, we run the very real risk of the type of implosion we’re seeing happen today.