Becker and Murphy confusion

In this Financial Times article, Nobel Prize winner Gary Becker and Clark Medal winner Kevin Murphy (both Chicago-school economists, and very good ones) argue that government just fails every time it tries to fix the economy so it should stay out.

The standard Chicago School argument is that markets work. Regulation is bad and only hinders economic growth. But there is one quite obvious thing they miss. Markets work when the incentives are correct. Alchian and Demsetz argued this probably 40 to 50 years ago. The incentives must be aligned so that everyone benefits.

Ben Klein further argued that firms (and people) can engage in opportunistic behavior and take advantage of these misaligned incentives to their own benefit. Williamson took that opportunistic behavior a step further by arguing that people (and firms) are self-interest seeking with guile.

Take that to the deregulated financial markets and you can see how the wrong incentives were created. As long as asset prices were thought to keep going up, there's no incentive to be careful in lending and investing. Then take those debts and reimagine them into some new financial instruments and sell them to unsuspecting firms. You get short-term gains for a few at the expense of long-term stability. In other words, there was no downside risk to these non-bank banks (see moral hazard).

The kicker to their argument against government intervention is that the government was bad in rescuing people from Katrina and poorly executed the war in Iraq. See Krugman's response here. They further argue that the Great Depression saw the world turn away from capitalism and towards government management of the economy and site slow growth in the undeveloped world. But what about those in the first world that mixed capitalism and government? What about the growth in the 1950s in the US? Great Britain? Germany (West)? Japan?

What is most surprising is that they say that derugulation (or insufficient regulation) was not the cause of this current crisis. The argument is that commercial banks didn't do so hot either and they're regulated heavily. But they fail to see the non-bank banks failures and complete collapse of those newly created financial instruments. I suggest they look back towards alignment of incentives and opportunistic behavior.