We’ve reached tougher economic times and, as always, people are complaining about the dangers of a free market. Free markets are risky, but what we’ve been experiencing since the Great Depression isn’t exactly a free market. At times, it hasn’t even been close. Before we start crying for more regulation, we should attempt to understand our economy and find out what caused this crisis.

A truly free market is volatile, but not catastrophically volatile. An economic cycle begins with optimistic people pouring lots of money into a variety of ventures. In their exuberance, they pour too much money into some, and prices soar. Eventually, some of these ventures fail, and the inflated prices for other ventures correct themselves. We call this a "correction", "recession", or "depression" depending on how severe it is. Most people fear this volatility, but it serves an important purpose: the booms are periods of creativity that bring forth new ideas, and the corrections weed out the bad ideas, make the economy more efficient, and encourage people to save money. When the correction is over, the saved money fuels the next boom. In a perfectly free market, these corrections happen frequently and don’t last long. The average person survives them just fine. That is, he survives unless he spends all of his money and accrues needless debt.

What, then, caused the current economic crisis? The first thing we should notice is that, for the last few decades, corrections have been neither frequent nor mild. This is caused by a government that believes it is responsible for eliminating economic suffering. Oddly enough, a perpetually good economy also helps politicians get reelected. Hmmm. Anyway, rather than accepting a necessary correction, the government will fiddle with interest rates and money supplies. Lower interest rates add money to the market because when interest rates are low, it makes sense for people to borrow more. With money floating around everywhere, prices climb higher, and people become even more optimistic. In their exuberance, they drive stock prices far above reasonable levels. Of course, the price must come back down if actual profits don’t justify it. The higher prices climb, the harder the resulting fall will be. That effect alone amplifies economic cycles, but there’s more too it. While the government holds interest rates artificially low, people borrow and spend as much as possible. Without a correction in the near past, they also forget about the tough times. People save less money and, after the market crashes, they don’t have a reserve on which to survive. This also means there is less money with which to start the next boom. The cycle gets interrupted.

At this point, people start panicking and looking for scapegoats. "It must have been caused by corrupt businessmen! Only the government can protect us!" sums up public opinion fairly well. With this public mandate for change, congress regulates. Regulation is interesting because it makes business slower and more expensive. The Sarbanes-Oxley Act, for example, was enacted after the Enron fiasco. In fact, Sarbanes-Oxley was enacted long after Enron’s corrupt behavior had already driven it out of business, but I digress. A practical result of this act was requiring roughly $3 million worth of paperwork before a company could offer public stock. This act obviously hasn’t protected us from the current financial disaster, but we know it has hurt the economy. When it becomes more expensive to do business, people do less of it. When people do less business, there are fewer jobs and, ironically, less tax revenue for the government to play with. In other words, increased regulation makes it even more difficult to recover from a recession.

When we piece it all together, the regulated economic cycle looks like this: There is a natural boom. When signs of a correction appear, the government interferes. Eventually, the government can’t interfere without other adverse effects – like inflation – and the resulting correction is severe. People complain very loudly, so the government regulates, making the problem worse.

The real estate bubble and the current financial crisis are classic examples of government interference. Fannie Mae and Freddie Mac were technically businesses like any other, but this was only a technicality. In reality, they were government sponsored organizations structured to operate like businesses. Their purpose was to provide cheap mortgages to encourage home ownership, and the government supplied low-interest cash to them. With cheap government money, Fannie and Freddie had an advantage over free market competitors, and they grew rapidly. They also had a mandate to provide home loans to people with low incomes, no savings, and bad credit ratings. An alarm should be going off in your head right now: Fannie and Freddie were purposely doing what the free market would not. It comes as no surprise, then, that they made bad loans. Normally, an unprofitable company would go bankrupt, and life would move on. Fannie and Freddie were so big that their failure would hurt everyone. As the saying goes, "If you owe the bank a thousand dollars, you have a problem. If you owe the bank a million dollars, the bank has a problem." To avoid this pain, the government has taken responsibility for their worst mortgages. What this means to you and me is that the government wrote them a huge check to keep them afloat, and we’re all going to pay for it.

Fannie and Freddie are specific examples within a larger problem. In the last week, the government has decided to spend $700 billion to bail out AIG and a few other financial institutions. In addition to paying the initial $700 billion, our economy will now have to endure businesses that should have gone bankrupt. These businesses not only have a record of failure, but also know the government will save them when they screw up. Because they no longer bear the cost of their mistakes, they will make more mistakes, and we will pay for them. Of course, the government will regulate this with predictably disastrous results. If this trend continues, we can all look forward to cycles of corporate stupidity followed by government interference – and a permanently damaged economy.

To be fair, some businessmen are corrupt, and their actions do hurt people. It is also possible to have a depression in a completely free market. We will never completely eliminate economic cycles because capitalism is risky and people are imperfect. However, the market hasn’t been completely free since before the Great Depression, and each round of government interference has led to more problems. Before taking action to reign in our current "free" market, we need to make sure our solutions aren’t worse than our problems.