This concept that in 2008 the market was responding to incentive misalignments created by government regulation.. what regulation? All we did was deregulate from 92 onwards. Are you gonna claim that a billion in fannie/freddie loans to minorities caused the problem? What about the overleveraging, the AAA credit ratings? Those were government problems?

It seems like a whole bunch of individuals played the "greater fool" theory as long as they could, and what we wound up with was the opposite of efficient, by your definition. I'm not necessarily saying more regulation would've prevented that, aside from generally being a brake on everything, but it's a hell of a bad case for the wisdom of markets.

This is false. The Community Reinvestment Act, passed in '92 and periodically ratcheted upwards thereafter, forced banks to increase loans to minority groups. It issued guidelines on how lenders should evaluate borrowers for these purposes:

Affirmative-action policies trumped sound business practices. A manual issued by the Federal Reserve Bank of Boston advised mortgage lenders to disregard financial common sense. "Lack of credit history should not be seen as a negative factor," the Fed's guidelines instructed. Lenders were directed to accept welfare payments and unemployment benefits as "valid income sources" to qualify for a mortgage. [1]

While not a regulation issue as such, it's also true that attempts to rein in Freddie Mac and Sallie Mae (semi-governmental entities both) were rebuffed by Congress; even when we knew there was potential trouble, the regulators wouldn't allow market concerns to dictate to their beast.

[1] http://www.boston.com/bostonglobe/editorial_opinion/oped/art... (note this link took forever to come up in my browser)

Where was the enormous arbitrage opportunity left behind, and why didn't you (or anybody else) exploit it?

Maybe you can answer that, but if you can't, you're not arguing for "inefficiency", you're still arguing "not good".

You also appear to be conceiving of regulations as something you simply have "more" or "less" of, which is not a useful mental model. What matters about regulations is their content, not their quantity. And what the content of our regulations created was A: mandating that banks make loans they would not have made without them and B: an implicit government backing for those bad loans.

Have you looked at the balance sheets for Fannie & Freddie lately? They're not bleeding a billion here or there.

Also, yes, the credit rating agencies are government creations as well. There are regulations (ahem) that require certain entities to take certain actions based on the word of the rating agencies, causing them to no longer just be groups of people stating their opinion, skewing their own incentives and raising the incentives others have to game them.

Anyways, 10 years is pretty darn not good in my opinion. I'd call it inefficient, as far as pricing is concerned.

Agree on "more or less" regulations being a not-useful mental model. It seems to follow from that contention that "regulations!" isn't a one-word answer to any question of who to blame for anything, or how to solve anything.

RE: Fannie and Freddie I have not looked at their balance sheets. I'm under the impression that whatever the problem is with them, it's dwarfed by the size of the financial crisis, ergo they're not primarily at fault for the crisis. Moreover, the program to lend to minorities had been in place for decades. Seems hard to blame it for the 2008 meltdown, why not sooner?

It does seem that any regulations putting institutional faith in the ratings agencies are wrong-headed.

Housing subsidies directed at minorities were increased over time in the Clinton and Bush administrations, but weren't large compared to the massive overall portfolio.

If we accept that the free market can act in ways which are detrimental to the global objective function (without loss of generality, let's pick your favorite, e.g., "Everyone gets food", "Individuals have class mobility", "I can shoot and eat the homeless for sport" etc.), do we as a society have a moral obligation to adjust market behavior via regulation or incentives? How does one reconcile a desire for free markets with a desire to satisfy other human goals?

I think it's possible to regulate effectively, but the problem is that it requires an engineer's approach, not a government's approach. One must be able to adapt, admit one is wrong, and generally regulate at the incentives, instead of being required to stay politically viable and only then regulate, be politically unable to admit error (and via the mechanisms of politics, become insulated from the facts that would show error), and be continuously stuck in the regulation of the effects instead of the incentives that got us there. Oh, and as I alluded to previously, being regulated by people who won't even look at the mechanics of the market squarely because they think they're intrinsically evil because sometimes they make bad things happen (which they definitely do!) isn't a great start to engineering success.

Yes. The market can be evil by human standards, just as gravity feels pretty evil when you're in a crashing plane. But you gotta deal with what really exists, not what you wish existed, and when harnessed properly it's one of the bigger forces for good we've ever discovered.

There are plenty of real-world examples of this. In all cases, free trade will make all parties better off on the whole. However, the effect of doing so may be that individuals at the margin lose out, e.g., an unskilled factory worker may find that someone in China is doing what used to be his job. It's pretty well decided now (although not without any controversy) that, at the margin, minimum wage laws increase unemployment in the lowest-paid workers.

The fact that some deregulation may have (localized) negative consequences shouldn't automatically disqualify them: there are more choices than just "let the market run free" vs "continue the regulation". We can, for example, get the benefits of that free trade, and use a portion of the economic gains to finance job retraining programs.

However, I'd also like to point out an implicit assumption in your question that may be problematic. You refer to "the global objective function". Part of our difficulty is that there isn't such a global function that all can agree on. Indeed, it may be that some of our utility functions are mutually exclusive. Many people would say that we should optimize for full employment, but I personally think that's bunk: there are plenty of people who don't want to work, but do so because they need to buy food; they'd rather take care of the kids while the spouse works. The adoption of a single utility function to govern the country (something, it seems to me, that both Conservatives and Liberals would like to see) sells out American individualism, and the diverse lifestyles and values of our people.

I argue that the only function that a free market can optimize for is the market itself; all other consequences such as happiness, fulfillment, distribution of experiences etc., are side effects which arise from coupling the market to the world via the decisions of participants, regulations, etc. Only if you assume perfect coupling of the market to the global objective is the system morally optimal.

In all cases, free trade will make all parties better off on the whole

This, however, makes it sound like you are assuming perfect coupling in the absence of any regulation, or that your objective function is the execution of the free market itself, and not, say, the well-being of the individuals and societies participating in it. I must not understand you correctly.

If we can agree that capital is the means by which a person can achieve fulfillment (I don't just mean by "being rich", obviously. It may enable the person to donate to charity; or that person's labor, which which has a monetary value, may achieve some end; or to obtain medical care to cure an ailment; etc.), then I can see an answer.

In the free trade example, opening borders to trade expands the economies of both nations. That's pretty much the same as saying that more capital is available within both nations, which means that -- across the whole population -- people are better able to move up their utility function (i.e., achieve self-actualization). In other words, because money -- capital -- has the power to buy or enable other things, then our positions may be compatible.

Of course, some individuals may benefit more than others, and indeed, some may find themselves worse off. That's where some would claim that we as a society owe compensation to some, to pay for our own gains.

Looking back at what I just wrote, it seems the crux of the argument, then, is the degree to which you can believe that capital can provide the answer to whatever your objective function is.

I'm going to reject the example of a market in slavery. This is the very epitome of a non free market. The slaves themselves are being forced into the transaction, and since a free market, by definition, requires rational actors entering the transaction of their own free will (because they all expect to be better off in the end), it cannot be considered free.

The classic examples of market failure are "tragedy of the commons" problems due to externalized costs, and public goods that would suffer "free rider" problems, like national defense. The externalization problems are due to our legal framework for property rights; a system that fully allocates property rights (e.g., some person owns this river; some person owns the air) would fix this, as demonstrated by the Coase Theorem. The free rider problem is stickier. They do turn out to be much rarer than people believe (e.g., the classic example is the lighthouse, but historical research shows that in the past, these have been provided by markets), but they're not entirely fictional, and I don't have a good answer to the overall question at the moment.