To some observers, the recent credit crisis is all the proof one needs to declare the free market dead.

A lethal combination of greed and deregulation has led to this economic upheaval, they say. And the only benefit from this turmoil is that a stake has finally been driven into the heart of the libertarian idea that markets unfettered by the intrusive hand of government will lead to prosperity.

Well, not quite, say free market defenders. For this notion ignores what role the hand of the government, and not the "invisible hand," may have played in the current situation.

First of all, there can be no death of the free market when the free market has never lived.

While the U.S. economy may be "freer" than most, it — like all economies — is entangled in governmental regulations and oversight.

The U.S. economy, like all national economies, is mixed, meaning the government plays some kind of intrusive role in guiding it along. While the U.S. economy may be "freer" than most, it — like all economies — is entangled in governmental regulations and oversight.

Some moan that under the Bush administration, the government has taken a hands-off approach to the banking industry. This, according to George Mason University economics Prof. Tyler Cowen, is a myth. He notes that spending for regulatory agencies is to grow by 6.4 per cent in the proposed 2009 fiscal budget.

"There was plenty of regulation — yet much of it made the problem worse," Cowen wrote recently in the New York Times. "These laws and institutions should have reined in bank risk while encouraging financial transparency, but did not."

Columbia Business School professor Charles Calomiris, also writing in the Times, adds that the deregulation that has occurred did not suddenly open the floodgates to certain banking practices, such as sub-prime lending. These were "all activities that banks and other financial institutions have had the ability to engage in all along. There is no connection between any of these and deregulation."

Government's role

So if, according to free market defenders, government regulation, or lack of it, isn't the culprit, what role did government play in the credit crisis?

What needs to be understood is that embedded in the American psyche is the dream of owning a home. And it's under this ideal that the U.S. government has set out goals to expand home ownership for low-income families. In this light, former president Bill Clinton established the National Homeownership Strategy in 1994 in an effort to increase home ownership. This policy was carried forward by President George W. Bush.

It apparently worked, as home ownership has increased from 63.8 per cent in 1994 to 69 per cent in 2006, peaking at 69.2 per cent in 2004.

But there were consequences.

Enter Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Mortgage Corporation), the government-sponsored mortgage lending institutions whose goals are to increase the funds available to potential homeowners. Simply put, these institutions bought mortgages from lenders and resold them to investors with the implicit understanding that the government would cover them if things went south.

It's this promise, defenders of the free market say, that is a main source of the current problems.

'If there's not the implicit guarantee from government that they're going to bail out Fannie and Freddie if their loans go badly, then it's pretty unlikely that all these banks are going to extend this incredibly risky lending," economist Jeffrey Miron, a lecturer at Harvard University, told CBCNews.ca. "They're just not going to take this kind of chance unless they think they have a reasonable shot of getting bailed out or protected against the worst-case scenarios."

Congress, along with the U.S. Department of Housing and Urban Development, pressured Fannie and Freddie to meet certain targets in financing affordable housing. But Miron said that following the accounting scandals at Fannie and Freddie in 2003, some members of Congress, particularly Democrats who were sympathetic to expanding affordable housing, put huge pressure on Fannie and Freddie to "up the ante."

In 2003, subprime mortgages made up less than 8 per cent of all mortgages. By 2006, that had risen to more than 20 per cent.— Columbia Business School professor Charles Calomiris

That pressure consisted of threatening Fannie and Freddie with regulation and reduced profits unless they extended credit more generously. This pressure trickled down to other lending institutions, which then gave mortgages to credit-risky individuals, Miron said.

"To stay in good favour with the government meant responding to the pressure," Miron said.

This is not to say that lenders sold these mortgages solely because of the pressure. As Miron explained, firms will try to maximize their profits. If the government is throwing money out the window, can they be blamed for standing underneath to catch it?

Calomiris calculates Fannie and Freddie became the largest buyers of what are known as subprime and alt-A mortgages (the mortgages at the root of this mess) between 2004 and 2007. He said their purchases stimulated the growth of this particular mortgage market. In 2003, subprime mortgages made up less than eight per cent of all mortgages. By 2006, that had risen to more than 20 per cent.

Perfect storm

While this was going on, interest rates were kept low (another government intervention), which helped contribute to a housing boom.

Miron said there was a "perfect storm" during the period between 2003 and 2006 — which included a combination of incentives to provide risky credit, pressure from Congress to extend that credit to low-income borrowers, and low interest rates.

Lastly, what about greed?

Well, like it or not, greed, or self-interest, or those seeking profit, or however you want to define it, is what motivates the economy. It's not a recent invention.

As Alvaro Vargas Llosa, director of the Center on Global Prosperity at the Independent Institute, recently wrote for the Washington Post Writers Group: "Wall Street firms were greedy, irresponsible and, in many cases, downright stupid. But those are fairly constant features in any society and there is no reason to believe that investment bankers were any more greedy, irresponsible and stupid in 2007 and 2008 than, say, five or 10 years earlier."

Many defenders of the free market will say there is a lot of blame to go around. Some will add that the market is not infallible because it's made up of fallible people.

What they balk at, however, is blaming current events on free market principles when those principles have really never been in place … and certainly weren't in the latest financial fiasco.