In the wake of the sub-prime crisis, there’s been a lot of nonsense talked about how the financial markets have proved unable to regulate themselves. Apparently intelligent people have been arguing that what we really need is greater government intervention in the markets.

In case these people hadn’t noticed, governments are already up to their necks in the markets, particularly the ones in the worst trouble. Fannie Mae (FNM) and Freddie Mac (FRE)– the twin financial neutron bombs underpinning the US mortgage sector – are Government Sponsored Entities (GSE) after all. They were created by the US Government to interfere with the property market because at some point the authorities decided that universal home ownership – like full employment – was a desirable goal in itself, regardless of whether people could actually afford a home or not.

Now the very existence of the GSEs threatens to bring down the financial system (you can read more about Fannie and Freddie here: How Fannie and Freddie are pulling the US towards crisis).

These knee-jerk calls for added regulation just show that despite all the talk of Thatcherite revolutions and how we’re all capitalists now, plenty of people still don’t understand how or why markets work.

One very obvious example of this is the constant indulgence of the idea of a windfall tax on energy companies…

How the market system is supposed to work

My colleague David Stevenson wrote about the specific stupidities of a windfall tax on energy on Friday (you can read it here: Why an energy windfall tax is a bad idea). But on a broader note, calls for a windfall tax just show how badly understood markets are. Let’s just clarify roughly how they are supposed to work.

If a good or service becomes expensive, that shows that there’s not enough of it to go around – there’s more demand than supply. The companies involved in the sector then make “excess” profits, or to put it more clearly, they rake it in because they were smart or lucky enough to be in the right place at the right time.

But this happy situation won’t last forever. Just as in the recent housing bubble, everyone else sees them making money hand over fist and decides “I’ll have a piece of that.” Or the company itself realises if it can make and sell more goods, it’ll make even bigger profits. One way or another, supply rises to meet demand, therefore driving down the price.

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Source: Why We Need Less Government Interference, Not More