I should qualify this by saying that my field is physics, not economics, but I think there's a strong argument you can make about the financial crisis that is not at all an indictment of the free market. My understanding of the financial crisis is that there's three primary culprits: 1) a systematic underestimation of credit risk, 2) excessive subprime lending, 3) mortgage derivatives linked to the excessive subprime lending (credit default swaps, CDOs that apparently no one knew how to quantify).
(1) seems to me the underlying factor. One interpretation of this is that bankers just used the wrong probability distribution to estimate risk (a normal instead of a Lorentz distribution, and a gaussian decays much faster than a Lorentz function, which follows a power law). Alright, but why? One answer, I guess, is that bankers (to paraphrase the unlamented Rumsfeld) didn't know what they didn't know. If you're modeling a chaotic system containing lots of recursive feedback loops, and things seem to be following a roughly bell-shaped curve, to start with, shouldn't you examine the function's asymptotic behavior carefully to make sure it's actually a bell curve, and not, for example, a Lorentz function, which has a completely different scaling form? Another, possibly more convincing answer, is that bankers just assumed that even though their mathematical model was incorrect, it wouldn't matter, because they could just use (in my opinion, absurdly complicated) derivatives to push the risk off onto the big investment banks, by way of Fannie Mae and Freddie Mac. Which are, of course, government-sponsored enterprises, which had, as I understand it, fairly explicit instructions from Congress to encourage subprime lending. At least some of the complex credit derivatives, and the special legal classifications built around them, were created by Fannie and Freddie, as well.
So, as a political football (and it's nothing if not that), there's plenty of blame to go around. From what I've read, there was plenty of bona fide stupidity involved. (Anecdotally, the guys I knew in college who went into banking didn't seem like the brightest folks around, but they were geniuses compared to the people who wanted to go into politics.) My understanding is that both John McCain and Barack Obama were complicit, although they're both dissembling ferociously and scrambling for the moral high ground. Not having Rick Davis blathering on his behalf has probably helped Obama in this regard. Congressional Democrats have firmly exonerated themselves, which makes no sense, but the Republicans see the whole economic mess as such electoral poison (economic issues tend to favor the Democrats, etc.) that they're not making an issue of it. This is reasonable short-term (read: electoral) but disastrous long-term politics, to say nothing of policy. The worst part is that the argument is so simple: the Republicans could really drive home the point that 1) the housing and financial markets were actually heavily regulated, 2) these regulations were a big part of the problem, so 3) in reality it wasn't anything like a free market, so this isn't an indictment of free market economics.
This doesn't mean the bailout is good or bad, and I really have no idea what ought to be done at this point. But I think the near-universal consensus that this was caused by an unregulated market run amok is wrong, and while I do think the bailout itself has to be very carefully regulated, I don't think a blind charge into more regulations on this or other markets is necessarily going to help. Obama's been quite vocal about McCain's history of deregulation, but unfortunately, McCain's response to this has been to recklessly invent schemes to out-regulate the Democrats. But hey, who needs principles when you can change the subject?
Sigh.
Further thoughts: I guess I should append to this that the actual unregulated markets were the secondary markets (credit default swaps and collateralized debt obligations), and it's the fact that each default had a huge number of derivatives attached to it that allowed the subprime crisis to amplify to the point where it could sink these huge investment banks. This is, of course, what everyone's focusing on, and why the Republicans are so leery about confronting the issue: the deregulation of the secondary markets was, I think, pushed through by Republicans. But the key point that often gets missed is that this only became an issue because of the heavily (but poorly) regulated mortgage market. To draw the analogy out a bit, everyone's up in arms trying to figure out how the signal got amplified (which is important), and completely ignoring the faulty wiring that produced the signal in the first place.
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