A free market is a market without economic intervention and regulation by government

except to regulate against force or fraud. This is the contemporary use of the terminology
used by economists and in popular culture; the term has had other uses historically. A
free market requires protection of property rights, but no regulation, no subsidization, no
single monetary system, and no governmental monopolies. It is the opposite of a
controlled market, where the government regulates prices or how property is used.

The theory holds that within the ideal free market, property rights are voluntarily
exchanged at a price arranged solely by the mutual consent of sellers and buyers. By
definition, buyers and sellers do not coerce each other, in the sense that they obtain each
other's property rights without the use of physical force, threat of physical force, or fraud,
nor are they coerced by a third party (such as by government via transfer payments) [1]
and they engage in trade simply because they both consent and believe that what they are
getting is worth more than or as much as what they give up. Price is the result of buying
and selling decisions en masse as described by the theory of supply and demand.

Free markets contrast sharply with controlled markets or regulated markets, in which
governments directly or indirectly regulate prices or supplies, which according to free
market theory causes markets to be less efficient.[2] Where government intervention
exists, the market is a mixed economy.

In the marketplace the price of a good or service helps communicate consumer demand to
producers and thus directs the allocation of resources toward consumer, as well as
investor, satisfaction. In a free market, price is a result of a plethora of voluntary
transactions, rather than political decree as in a controlled market. Through free
competition between vendors for the provision of products and services, prices tend to
decrease, and quality tends to increase. A free market is not to be confused with a perfect
market where individuals have perfect information and there is perfect competition.

Free market economics is closely associated with laissez-faire economic philosophy,

which advocates approximating this condition in the real world by mostly confining
government intervention in economic matters to regulating against force and fraud among
market participants. Some free market advocates oppose taxation as well, claiming that
the market is more efficient at providing all valuable services of which defense and law
are no exception, that such services can be provided without direct taxation and that
consent would be the basis of political legitimacy making it a morally consistent system.
Anarcho-capitalists, for example, would substitute arbitration agencies and private
defense agencies.

In social philosophy, a free market economy is a system for allocating goods within a
society: purchasing power mediated by supply and demand within the market determines
who gets what and what is produced, rather than the state. Early proponents of a free-
market economy in 18th century Europe contrasted it with the medieval, early modern,
and mercantilist economies which preceded it.

Background and causes

The immediate cause or trigger of the crisis was the bursting of the United States housing
bubble which peaked in approximately 2005–2006.[10][11] High default rates on "subprime"
and adjustable rate mortgages (ARM), began to increase quickly thereafter. An increase
in loan packaging, marketing and incentives such as easy initial terms and a long-term
trend of rising housing prices had encouraged borrowers to assume difficult mortgages in
the belief they would be able to quickly refinance at more favorable terms. However,
once interest rates began to rise and housing prices started to drop moderately in 2006–
2007 in many parts of the U.S., refinancing became more difficult. Defaults and
foreclosure activity increased dramatically as easy initial terms expired, home prices
failed to go up as anticipated, and ARM interest rates reset higher.

Growth of the housing bubble

[edit] Easy credit conditions

[edit] Sub-prime lending

[edit] Predatory lending

[edit] Deregulation

• In October 1982, President Ronald Reagan signed into Law the Garn-St. Germain
Depository Institutions Act, which began the process of Banking deregulation that
helped contribute to the savings and loan crises of the late 80's/early 90's, and the
financial crises of 2007-2010. President Reagan stated at the signing, "all in all, I
think we hit the jackpot".[60]
• In November 1999, President Bill Clinton signed into Law the Gramm-Leach-
Bliley Act, which repealed part of the Glass-Steagall Act of 1933. This repeal has
been criticized for reducing the separation between commercial banks (which
traditionally had a conservative culture) and investment banks (which had a more
risk-taking culture).[61][62]
• In 2004, the Securities and Exchange Commission relaxed the net capital rule,
which enabled investment banks to substantially increase the level of debt they
were taking on, fueling the growth in mortgage-backed securities supporting
subprime mortgages. The SEC has conceded that self-regulation of investment
banks contributed to the crisis.[63][64]
• Financial institutions in the shadow banking system are not subject to the same
regulation as depository banks, allowing them to assume additional debt
obligations relative to their financial cushion or capital base.[65] This was the case
despite the Long-Term Capital Management debacle in 1998, where a highly-
leveraged shadow institution failed with systemic implications.
• Regulators and accounting standard-setters allowed depository banks such as
Citigroup to move significant amounts of assets and liabilities off-balance sheet
into complex legal entities called structured investment vehicles, masking the
 weakness of the capital base of the firm or degree of leverage or risk taken. One
news agency estimated that the top four U.S. banks will have to return between
$500 billion and $1 trillion to their balance sheets during 2009.[66] This increased
uncertainty during the crisis regarding the financial position of the major banks.[67]
Off-balance sheet entities were also used by Enron as part of the scandal that
brought down that company in 2001.[68]
• As early as 1997, Fed Chairman Alan Greenspan fought to keep the derivatives
market unregulated.[69] With the advice of the President's Working Group on
Financial Markets,[70] the U.S. Congress and President allowed the self-regulation
of the over-the-counter derivatives market when they enacted the Commodity
Futures Modernization Act of 2000. Derivatives such as credit default swaps
(CDS) can be used to hedge or speculate against particular credit risks. The
volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates
of the debt covered by CDS contracts, as of November 2008, ranging from US$33
to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to
$683 trillion by June 2008.[71] Warren Buffett famously referred to derivatives as
"financial weapons of mass destruction" in early 2003.[72][73]

[edit] Increased debt burden or over-leveraging

• Free cash used by consumers from home equity extraction doubled from $627
billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of
nearly $5 trillion dollars over the period, contributing to economic growth
worldwide.[74][75][76] U.S. home mortgage debt relative to GDP increased from an
average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion.[77]

• USA household debt as a percentage of annual disposable personal income was

127% at the end of 2007, versus 77% in 1990.[78]

• In 1981, U.S. private debt was 123% of GDP; by the third quarter of 2008, it was
290%.[79]

• From 2004-07, the top five U.S. investment banks each significantly increased
their financial leverage (see diagram), which increased their vulnerability to a
financial shock. These five institutions reported over $4.1 trillion in debt for fiscal
year 2007, about 30% of USA nominal GDP for 2007. Lehman Brothers was
liquidated, Bear Stearns and Merrill Lynch were sold at fire-sale prices, and
Goldman Sachs and Morgan Stanley became commercial banks, subjecting
themselves to more stringent regulation. With the exception of Lehman, these
companies required or received government support.[80]

• Fannie Mae and Freddie Mac, two U.S. Government sponsored enterprises,
owned or guaranteed nearly $5 trillion in mortgage obligations at the time they
were placed into conservatorship by the U.S. government in September 2008.[81][82]
These seven entities were highly leveraged and had $9 trillion in debt or guarantee
obligations, an enormous concentration of risk; yet they were not subject to the same
regulation as depository banks.

[edit] Financial innovation and complexity

[edit] Incorrect pricing of risk

[edit] Boom and collapse of the shadow banking system

[edit] Commodity bubble

Global copper prices.

Nickel prices boomed in the late 1990's, then the price of nickel imploded from around
$51,000 /£36,700 per metric ton in the May of 2007 to about $11,550/£8,300 per metric
ton in the January of 2009. Prices were only just starting to recover as of January 2010,
but most of Australia's nickel mines had gone bankrupt by then[98]. As the price for high
grade nickel sulphate ore recovered in 2010, so did the Australian mining industry[99].

[edit] Systemic crisis

• "Manager's capitalism" which he argues has replaced "owner's capitalism,"

meaning management runs the firm for its benefit rather than for the shareholders,
a variation on the principal-agent problem;
• Burgeoning executive compensation;
• Managed earnings, mainly a focus on share price rather than the creation of
genuine value; and
• The failure of gatekeepers, including auditors, boards of directors, Wall Street
analysts, and career politicians.

Role of economic forecasting

Financial markets impacts

Impacts on financial institutions

2007 bank run on Northern Rock, a UK bank

The International Monetary Fund estimated that large U.S. and European banks lost more
than $1 trillion on toxic assets and from bad loans from January 2007 to September 2009.
These losses are expected to top $2.8 trillion from 2007-10. U.S. banks losses were
forecast to hit $1 trillion and European bank losses will reach $1.6 trillion. The IMF
estimated that U.S. banks were about 60 percent through their losses, but British and
eurozone banks only 40 percent.[114]
One of the first victims was Northern Rock, a medium-sized British bank.[115] The highly
leveraged nature of its business led the bank to request security from the Bank of
England. This in turn led to investor panic and a bank run in mid-September 2007. Calls
by Liberal Democrat Shadow Chancellor Vince Cable to nationalise the institution were
initially ignored; in February 2008, however, the British government (having failed to
find a private sector buyer) relented, and the bank was taken into public hands.

[edit] Credit markets and the shadow banking system

During September 2008, the crisis hits its most critical stage. There was the equivalent of
a bank run on the money market mutual funds, which frequently invest in commercial
paper issued by corporations to fund their operations and payrolls. Withdrawal from
money markets were $144.5 billion during one week, versus $7.1 billion the week prior.
This interrupted the ability of corporations to rollover (replace) their short-term debt. The
U.S. government responded by extending insurance for money market accounts
analogous to bank deposit insurance via a temporary guarantee[117] and with Federal
Reserve programs to purchase commercial paper. The TED spread, an indicator of
perceived credit risk in the general economy, spiked up in July 2007, remained volatile
for a year, then spiked even higher in September 2008,[118] reaching a record 4.65% on
October 10, 2008.

In a dramatic meeting on September 18, 2008 Treasury Secretary Henry Paulson and Fed
Chairman Ben Bernanke met with key legislators to propose a $700 billion emergency
bailout. Bernanke reportedly tells them: "If we don't do this, we may not have an
economy on Monday."[119] The Emergency Economic Stabilization Act also called the
Troubled Asset Relief Program (TARP) is signed into law on October 3, 2008.[120]

This meant that nearly one-third of the U.S. lending mechanism was frozen and
continued to be frozen into June 2009.[121] According to the Brookings Institution, the
traditional banking system does not have the capital to close this gap as of June 2009: "It
would take a number of years of strong profits to generate sufficient capital to support
that additional lending volume." The authors also indicate that some forms of
securitization are "likely to vanish forever, having been an artifact of excessively loose
credit conditions." While traditional banks have raised their lending standards, it was the
collapse of the shadow banking system that is the primary cause of the reduction in funds
available for borrowing.[122]

Wealth effects

There is a direct relationship between declines in wealth, and declines in consumption

and business investment, which along with government spending represent the economic
engine. Between June 2007 and November 2008, Americans lost an estimated average of
more than a quarter of their collective net worth. By early November 2008, a broad U.S.
stock index the S&P 500, was down 45 percent from its 2007 high. Housing prices had
dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential
drop. Total home equity in the United States, which was valued at $13 trillion at its peak
in 2006, had dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total
retirement assets, Americans' second-largest household asset, dropped by 22 percent,
from $10.3 trillion in 2006 to $8 trillion in mid-2008. During the same period, savings
and investment assets (apart from retirement savings) lost $1.2 trillion and pension assets
lost $1.3 trillion. Taken together, these losses total a staggering $8.3 trillion.[123] Since

[edit] Global contagion

The crisis rapidly developed and spread into a global economic shock, resulting in a
number of European bank failures, declines in various stock indexes, and large reductions
in the market value of equities[130] and commodities.[131]

Both MBS and CDO were purchased by corporate and institutional investors globally.
Derivatives such as credit default swaps also increased the linkage between large
financial institutions. Moreover, the de-leveraging of financial institutions, as assets were
sold to pay back obligations that could not be refinanced in frozen credit markets, further
accelerated the liquidity crisis and caused a decrease in international trade.

World political leaders, national ministers of finance and central bank directors
coordinated their efforts[132] to reduce fears, but the crisis continued. At the end of
October 2008 a currency crisis developed, with investors transferring vast capital
resources into stronger currencies such as the yen, the dollar and the Swiss franc, leading
many emergent economies to seek aid from the International Monetary Fund.[133][134]

Effects on the global economy

Main article: Late-2000s recession

Global effects

Some developing countries that had seen strong economic growth saw significant
slowdowns. For example, growth forecasts in Cambodia show a fall from more than 10%
in 2007 to close to zero in 2009, and Kenya may achieve only 3-4% growth in 2009,
down from 7% in 2007. According to the research by the Overseas Development
Institute, reductions in growth can be attributed to falls in trade, commodity prices,
investment and remittances sent from migrant workers (which reached a record $251
billion in 2007, but have fallen in many countries since).[145]

By March 2009, the Arab world had lost $3 trillion due to the crisis.[146] In April 2009,
unemployment in the Arab world is said to be a 'time bomb'.[147] In May 2009, the United
Nations reported a drop in foreign investment in Middle-Eastern economies due to a
slower rise in demand for oil.[148] In June 2009, the World Bank predicted a tough year for
Arab states.[149] In September 2009, Arab banks reported losses of nearly $4 billion since
the onset of the global financial crisis.[150]
U.S. economic effects

[edit] Official economic projections

Responses to financial crisis

Emergency and short-term responses

Regulatory proposals and long-term responses