Free = ruled by foreign governments

In the wake of the financial crisis and the subsequent recession, many of us have decried the "free-market fundamentalism" of economists and politicians who insist that the government has no role to play in the economy. We were right to do so. One reason we were right is that the alternative to U.S. government intervention in the economy is not, in many instances, an economy governed by the action of private individuals - instead, as Brad Setser explains, it is one governed by the choices of foreign governments.

Case in point - deregulation of finance was supposed to allow capital to flow to more efficient uses, because private investors will be better at identifying profitable investments. But at the same time, China's government and UAE's government were flooding our economy with cheap money. So our financiers and households were not forced to live within the limits of true productive efficiency - the "free market" was actually a market distorted by Chinese and UAE policy.

Another case in point. By manipulating its currency, China biased the terms of its trade with the U.S. Yes, China had lower wages than us, but the gap would not have been nearly as big if China hadn't spent billions making its currency cheap. That means that many of the American manufacturing workers who lost their jobs were actually more efficient than the Chinese workers that replaced them.

A third case in point. China's government used (and uses) massive government subsidies to encourage capital-intensive industry. This is counter to the natural tendency of the market - Chin has a lot of labor, and the West and Japan have a lot of capital, so in order to be efficient we should sell China capital-intensive goods and services and get labor-intensive goods and services in return; we should sell them steel and they should sell us toys. But because China's government decided it wanted a big steel industry, we sell China food and minerals (and government debt), and they sell us both steel and toys.

In all of these cases, foreign (mostly Chinese) government policy has moved not only their economy but also ours away from the efficient optimum. That has probably held back GDP and reduced employment and wages in both China and the U.S. It has probably redistributed wealth from the poor to the rich in both China and the U.S. And it has exposed both China and the U.S. to the danger of policy uncertainty - when China's government one day wakes up and decides to cancel one policy or another, or stops being able to keep it up, the economy will "snap back" towards the efficient optimum and the rapid readjustment will be painful.

If our government had maintained larger role in the economy, it might have been able to somewhat balance out the distortions arising from Chinese and Arab governments. We might have regulated our financial system better and prevented a bubble. We might have been able to use the threat of protectionism to discourage China from its mercantilist exchange-rate policy (though I'm less certain about this one, since carrying out the threat would have been destructive and costly).

So "free-market fundamentalism" often just resulted in someone else's government calling the shots. Is that what we want?