Economic Crisis Stirs Free-Market Debate The steps taken to prevent an economic collapse have challenged longstanding assumptions about the operation of modern free-market capitalism championed by Adam Smith, and the role of the government in the economy.
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Economic Crisis Stirs Free-Market Debate

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Economic Crisis Stirs Free-Market Debate

Economic Crisis Stirs Free-Market Debate

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The United States, along with the rest of the world, appears to be slowly emerging from the worst economic crisis since the Great Depression. Now comes the debate over what lessons we should take away from the experience and, over the next few weeks, we'll consider the future of capitalism itself.

We open our series with a look at how the events of the past year could change the way we think about free markets and the role of the government. Here's NPR's Tom Gjelten.

TOM GJELTEN: The idea of capitalism as an economic system was explained more than 200 years ago by the Scotsman Adam Smith. In his book, "The Wealth of Nations," Smith said a free market guides society to efficiency by bringing buyers and sellers together and stimulating economies to produce more of what's needed and less of what's not.

In the United States, the best known apostle of free-market capitalism was the legendary economist Milton Friedman, who died in 2006. Back in 1980, in a 10-part television series called "Free to Choose," Friedman made the case for Adam Smith's capitalism model.

(Soundbite of TV show, "Free to Choose")

Mr. MILTON FRIEDMAN (Economist): His key idea was that self-interest could produce an orderly society benefiting everybody. It was as though there were an invisible hand at work.

GJELTEN: The invisible hand of the free market destroys companies that can't compete. But it lifts up companies with good ideas, ones that sell. The Austrian economist Joseph Schumpeter called this creative destruction.

Free market true believers say governments generally should stand back and let this process run its course. That pro-market, keep-the-government-out philosophy reached a heyday in the 1980s in Britain under Margaret Thatcher and in the United States under Ronald Reagan.

President RONALD REAGAN: I've always felt the nine most terrifying words in the English language are: I'm from the government, and I'm here to help.

GJELTEN: But last year, the global economy nearly went into full meltdown. Here in the U.S., the Bush administration felt it had no choice but to intervene in the marketplace to save companies whose failures would have set off dangerous chain reactions - first, the mortgage giants Fannie Mae and Freddie Mac, then the insurance giant, AIG.

The market had allowed them to make bad investments that put institutions around the world at great risk. Many economists, including some from Wall Street like Robert Barbera, said the lesson was that free-market ideology had been carried too far.

Mr. ROBERT BARBERA (Economist; Author, "The Cost of Capitalism"): We sort of morphed from Adam Smith's invisible hand, that markets move things in a very helpful direction, to some notion of free markets have an infallible hand.

GJELTEN: The simple capitalism model that Adam Smith described no longer fit the complicated, highly interconnected global economy of today. In his book "The Cost of Capitalism," Robert Barbera says it's time to update our economic thinking. Take Joseph Schumpeter's idea that it's good for companies to fail and others to take their place - usually it makes sense, Barbera says, but not always.

Mr. BARBERA: Wal-Mart appears. It's very innovative, and many, many small retailers over time are put out of business. That's the price of progress. That's Schumpeter's creative destruction. Conversely, when you're in a position when a great many financial institutions have lent the wrong way and there's this chance for a domino-like default, there's nothing creative about that destruction. You've got to prevent it. That's the cost of capitalism. Periodically, you will have to come to the rescue of the financial system.

GJELTEN: The Bush administration, generally conservative and pro-market, came to this very conclusion when it rescued the world's biggest insurance company, AIG. Clearly, we had broken new ground in economic thinking.

Not surprisingly, free-market purists have objected to these moves. They say the government should just let troubled companies go down, no matter how big they are.

Dr. THOMAS WOODS (Fellow, Ludwig von Mises Institute; Author, "Meltdown"): How, going forward, are we going to avoid a situation like this unless we say, in a few cases, look, that's it?

GJELTEN: Thomas Woods is a fellow at the libertarian Ludwig von Mises Institute.

Dr. WOODS: I'm telling you, that would have more of a salutary effect than all the regulatory tinkering put together. If these guys saw that, you know what? They're just like everybody else: if they don't produce, then they fail. They're just like the guy who's a mechanic, the guy who's a plumber. They enjoy no special privileges.

GJELTEN: Woods' new book is called "Meltdown."

Actually, there's nothing new about American capitalism changing in response to developments in the economy. When the free-market system allowed monopolies to emerge in the 19th century, the Interstate Commerce Commission was created to control them. And the Great Depression, 70 years ago, brought another layer of government intervention in the U.S. economy.

The free-market champion Milton Friedman, in fact, said the U.S. government erred during the Depression by not intervening quickly enough. In his "Free to Choose" TV series, Friedman explained how the failure of one private New York bank in 1931 set in motion a whole series of bank failures around the country. It was, Friedman said, an emergency situation that called out for an intervention by the U.S. Federal Reserve, but it did not come.

(Soundbite of TV show, "Free to Choose")

Mr. FRIEDMAN: The Federal Reserve system stood idly by when it had the power and the duty and the responsibility to provide the cash that would have enabled the banks to meet the insistent demands of their depositors without closing their doors.

GJELTEN: It's now widely accepted, even by most pro-market economists, that in a financial crisis, the government needs to intervene, even aggressively. Brad DeLong, an economist at the University of California at Berkeley, says what sets economic thinkers apart from each other these days are their ideas about what governments should do besides rescue troubled banks.

Professor BRAD DELONG (Economist, University of California, Berkeley): Most economists to the left of Friedman will say well, yes, this is one example where the government needs to intervene actively, but there are lots of others, too.

GJELTEN: And this is where the debate is now. The U.S. government, last fall under President Bush and then under President Obama, has gone well beyond rescuing banks. The practice of American capitalism, DeLong points out, has fundamentally changed.

Prof. DELONG: Remember those days in September when we woke up and found that the U.S. taxpayer now owned two large mortgage companies and an insurance company, AIG? And now we're going for auto companies, and who knows what's going to go next? The U.S. government is taking over an awful lot of things and expanding its role in the economy quite strongly and quite aggressively.

GJELTEN: President Obama says he doesn't want the U.S. government's majority ownership of General Motors to mean Washington runs the company, but his administration is demanding more fuel-efficient vehicles. He says he's a strong believer in the power of the free market, but that statement came even as he proposed regulatory reforms that would bring the biggest government intrusion into the private sector in more than 70 years. And then there are the administration's plans for energy and health care reform, both of which feature major new government roles.

Our free-market capitalist system will survive, but with each new economic crisis, some guiding principles get revised.

Tom Gjelten, NPR News, Washington.

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