Markets don't kill investors - bad decisions do

(breakingviews.com) -- Billionaire George Soros has pledged $50 million to a new foundation that will seek an alternative to what he calls "market fundamentalism."

But the false assumptions in modern financial theory -- abetted by laxity in monetary policy and government meddling in housing -- played a much bigger role in the crash of 2008 than free markets did.

Soros, who famously made $1 billion betting against the Bank of England in 1992, is a long-standing critic of free markets. It is thus unsurprising that he blames an excess of laissez-faire capitalism for last year's financial meltdown and the subsequent severe recession.

Yet the fingerprints of government are all over the crash, perhaps especially in the U.S. The Federal Reserve pursued an interventionist monetary policy from 1995, expanding M3 money supply significantly faster than growth in nominal GDP, and relatively faster than in the inflationary 1970s. That produced a series of asset bubbles.

Meanwhile, the government's explicit and implicit support of housing finance through Fannie Mae, Freddie Mac and in other ways helped produce a mortgage market in which originators could avoid responsibility for credit risk, even as they lent with the government's blessing to increasingly stretched borrowers.

Even on Wall Street, the appearance of free markets was deceptive. The prevailing modern financial theory rested on a number of erroneous assumptions. It assumed not only that price movements were random, but that extreme events were so unlikely they could be almost completely ignored.

Financial models mostly assumed that volatility was constant or varied only slowly, ignoring the numerous historical examples of crisis situations when it jumped discontinuously. And the theory assumed that complex correlations could be measured with precision, and did not vary much.

Given these errors, it's not surprising that a market that rested on modern financial theory went wrong. Soros may be right that economic theory needs a rethink. But what's needed isn't an alternative to free markets. It's a free market system that works.