Is free markets' failure the government's fault?

Some "market imperfections... are significant enough to warrant some form of government intervention," admitted Charles I. Plosser, the free-market-oriented economist who runs the Federal Reserve Bank of Philadelphia and represents our struggling regional economy to Fed chairman Ben Bernanke, to his fellow Union League of Philadelphia members in this speech today.

For example, the SEC rightly bans insider trading, he noted.

But Plosser warned that "the tension between our desire for economic stability and our desire for prosperity" has lately sparked "a masssive financial reform law that will generate many new regulations," in a nation where "attempts to insure against bad economic outcomes can sometimes be counterproductive," and "good intentions...yield ugly results," such as a "different crisis" and a  slower economy.

"The financial crisis was not a failure of our capitalist system," Plosser insisted. "Nor was it largely the result of a lot of greedy evildoers whom we could just put in jail to solve the problem.

"Rather, it largely reflected a collection of incentives, some arising in private markets and some created by the government, that motivated individuals to act in ways that proved damaging to the nation's overall economy."

Plosser held off criticizing Obama's new bank reform law. He even called its consumer-protection and credit-claims provisions "a step in the right direction" by setting ground rules to replace "regulatory discretion."

But mostly he leaned on past examples of "bad incentives" that are still with us:

- "Our tax code encourages reliance on debt financing, over equity financing, by making interest payments tax deductible for the (issuer), while dividend payments are not."

- "American consumers have been living beyond their means with too much debt... Our tax code has encouraged such behavior by allowing interest payments to be deducted (from taxes), while taxing capital gains" and dividends to investors.

- "The tax deduction for mortgage interest skews the decision between being a homeowner and a renter."

- The federal "goal of increasing homeownership rates" created "some of the most serious distortions" by allowing Fannie Mae and Freddie Mac to be "thickly capitalized and highly leveraged" so it "became very profitable for them to grow their portfolios" unil they were "too big to fail" and demanded government bailouts.

- Fannie and Freddie drove "ordinary banks" out of the conventional mortgage market into risky "jumbo and subprime" home loans that "exacerbated the problem."

- Federal deposit insurance "reduces the incentives of depositors to monitor the risk-taking of their bank."

- The federal bankruptcy code gives short-term lenders preference over long-term investors, which gave "incentives for (investment banks) to borrow very short and lend long," which "proved a debilitating strategy" in the late financial crisis.

Plosser called for "better" instead of "more" regulation; he was short on specifics, but longer on principles: "Asking government to insure all manner of firms and individuals agianst bad economic outcomes" will only slow "innovation and econmic growth," he concluded. "We might have less volatility, and, perhaps, less inequality, but we would also have a lower standard of living."