Charles Wheelan, Ph.D. The Naked Economist

When I heard Alan Greenspan's testimony before Congress last Thursday, I had one immediate thought: This is the beginning of the end for the free-market ideologues.

According to press reports of the testimony, Greenspan told Congress that he "had put too much faith in the self-correcting power of free markets." That's no small statement.

In fact, it struck me that if 1989 was the year when no reasonable person could still believe in communism (or any of its government-intensive relatives), then 2008 will go down in history as the year in which the free-market zealots saw their "wall" come crumbling down.

Too Free to Last

You don't have to take it from me. Just look around. One by one, the economic meltdown is slaying one shibboleth of the uber-free-market camp after another.

Here are some of the inflexible, hardcore beliefs that are crashing along with the stock market:

• Individuals always know best

Not so much, it turns out. The whole financial crisis is rooted in irrational personal decisions. Consumers borrowed more than they could afford based on the naive assumption that housing prices would always go up. Not just a few people -- lots and lots of them.

• Firms always manage resources better than government

Let's take a poll of Lehman Brothers shareholders to see how they feel about that statement. One of the most remarkable things about the whole crisis is the amount of wealth destroyed by private firms. The shareholders and managers of firms like Bear Stearns, Lehman, AIG, Countrywide, and others destroyed themselves.

That can't be blamed on flawed regulation. No matter how bad the regulatory scheme, it's never rational for private firms to destroy themselves along with all of the wealth of their shareholders.

It's definitely true that government incompetence deserves a share of the blame (e.g., Fannie and Freddie, or the push to put low-income citizens in homes they couldn't afford), but that doesn't make blindly eliminating regulations the answer. Deregulation and sensible regulation are not synonymous.

• Tax cuts are an economic miracle balm

I suppose one could argue that the economy would be in even worse shape right now without the Bush tax cuts -- but that's pretty thin gruel. The more reasonable argument is that the deficits that have accumulated over the last eight years -- during relatively good economic times -- are a hugely destabilizing force going forward. Everything happening right now is made much worse by the fact that the United States is highly indebted to the rest of the world. The ideologues pushed tax cuts without demanding corresponding spending cuts, and that's just plain irresponsible.

Three entities borrowed recklessly over the past decade: homeowners, Wall Street, and the U.S. government. So far, only two of them have had their reckoning.

• Less government is always better

I don't think most Americans are prepared to tell Hank Paulson and Ben Bernanke to leave the markets alone right now. Nor are they pushing for the FDIC to scrap the insurance on bank deposits. And many of us are wondering: 1) What is a credit default swap? 2) How could something I've never heard of be destabilizing the economy? and 3) Why didn't someone do something about this?

Does all of this mean that economics books should be burned and Nobel Prizes returned to Stockholm? Absolutely not. The free-market zealots were never right in the first place; they twisted, bastardized, and oversimplified conventional economic thinking. They saw simplicity where the bulk of economists saw tradeoffs and qualifications. They clung to simple and elegant views despite all evidence to the contrary -- and the analysis in the first 10 chapters of any basic microeconomics text.

A colleague of mine, who worked in (and was frustrated by) the George W. Bush administration, coined a term that summarizes it best: faith-based economics. That's not supposed to be how it works.

• Mainstream economists have a profound belief in markets

But they also understand that markets fail in some cases. And they recognize that most markets work better with some government infrastructure, whether it's information, modest regulation, or just a place to sue someone who cheats you.

Mainstream economists recognize the costs of taxation; taxes take money out of people's pockets and distort behavior in ways that can have serious economic costs. But the non-ideologues also recognize that tax revenues can be used to provide government services that make people better off. Good policy is about managing that messy tradeoff.

Mainstream economists recognize that individuals have a pretty good idea of what they want -- but that those same individuals sometimes make systematic errors of judgment, which can lead to things like bubbles and panics.

Mainstream economists recognize that too much regulation can harm innovation and diminish prosperity. But they also recognize that sensible regulation provides information and security, both of which make it much easier to do business with strangers. Regulation also protects third parties from market behavior that has negative spillovers, whether it's the guy who drinks too much at the bar before getting into his car or the paint factory that cuts costs by dumping lead in your drinking water.

A Monument to Self-Interest

There's now a museum in Berlin where visitors can go to see a remnant of the Berlin Wall and learn about the damage done by an overly rigid, poorly conceived ideology.

Maybe there should be some kind of 2008 Meltdown Museum. It would have a large subdivision of homes, all with "for sale" signs out in front. And there would be a quotation from Alan Greenspan inscribed over the arch at the entrance:

"Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief."