2008 will go down as the year the free market died. Deregulation in private capital markets has dealt itself a mortal blow. In the last few months, world governments have taken positions in private companies and banks, have decided which companies to rescue and which to let fail, and have adjusted currency prices across the globe. Over the next few months, lawmakers will draft legislation to more aggressively monitor, regulate, and restrain market activity.

In the face of such a massive implosion, we’re left to wonder where it goes from here. Do these developments vindicate Marx? Do they portend a transition in the U.S. toward socialism?

But in the aftermath of market disaster lies an opportunity to develop a more appropriate model for the market for the next century. This new market system won’t be a production of the actuarial-economist mind as much as of the social-scientific community. But before we build anew, let’s take a moment to reflect on some of problems last year’s reasoning.

1. In practice, free markets can never truly be free

Whenever the business cycle hits a major downturn, the rhetoric flies over how markets are efficient so long as they are free of onerous government intrusion. But this time around, Alan Greenspan apologized for that kind of irrationality.

… a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets…. Representative Henry A. Waxman of California, chairman of the committee [asked Mr. Greenspan:] “Do you feel that your ideology pushed you to make decisions that you wish you had not made?” Mr. Greenspan conceded: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”

In economic theory, none of this was supposed to happen. Markets are supposed to be efficient at figuring out prices and thwarting wide-scale fraud. But the theory presumes the markets are truly free—something that they can never be—so we have no empirical evidence to support that assertion. Ironically, private companies are now pleading for government intervention, even at the cost of giving up shares of their companies and allowing tighter oversight.

2. Government regulation is neither the poison nor the remedy

If a government agency (the Fed) sets the financial crisis in motion through deregulation, can another government agency (i.e. Congress) restore order? It’s axiomatic that whatever private industry does, government does worse. Being bailed out by the government is as much a curse as a blessing. And who will bailout the government after it runs banks and car manufacturers into the ground?

3. Markets depend on trust, but self-interested egoists don’t engender trust

When it comes to social trust, free markets are freeloaders. Free markets are most efficient when a high degree of social capital exists, but the “flaw” Greenspan alludes to is simply the friction between egotism and trust. It turns out that trust, not egotism, is what keeps a market in check. But markets today encourage risky, self-centric, and flamboyant behavior. The Laws of Relation predict that relationships set up in this way result in everyone being worse off.

4. Markets don’t resolve social dilemmas collaboratively

Markets are attuned to transferring risks and setting prices, but they only exacerbate social dilemmas. A social dilemma is a situation in which all actors are motivated to pursue self-interest, but in so doing make the general environment worse off.

The New Market

Over the last few decades, researchers have uncovered a great deal of information about what enables people to trust and cooperate. New Market rules should take note of these developments.

While some dismiss words like “trust” and “social capital” as vague, emotional concepts that don’t produce measurable results, new approaches to social trust make these terms palpable. Here’s an excerpt from one of my previous posts on restoring social trust:

What the world needs now is a renewed social trust. Until recently, social trust seemed like an intangible commodity with a will of its own; it couldn’t be systematically cultivated, measured, forecasted, or valued. But a growing canon of research into successful resolutions of social dilemmas demonstrates that collaborative arrangements are more likely to emerge when certain conditions are met. It’s time to develop mechanisms that foster pro-social behaviors by supporting natural processes of recognition, reciprocity, and community awareness. Most of the fundamental research is available to build such a system, so it’s more a matter of applying these ideas to real world relations, institutions, and markets.

The first step is to revisit free-market theory, as Greenspan suggested, and recast core concepts around self-interested parties. Can we conceive of a marketplace in which parties’ self-interest aligns with the common good?