Economist Raghuram Rajan warned in 2005 that the financial markets were in trouble

Economist Raghuram Rajan (a well-respected free-market economist) warned the Fed, bankers and economists that the financial system was headed for trouble, and much of what he specified has come to pass. Why was he ignored?

The Wall Street Journal has an article with one explanation and with links to other helpful articles. Here's part of the explanation from the Wall Street Journal:

The episode suggests one reason that the crisis went unchecked: A dangerous all-or-nothing orthodoxy had come to dominate the policy debate, where one was either for free markets or against them.

Another reason that many policymakers may have missed the risks is that macroeconomists didn’t have a good understanding of the changes that were occurring within financial markets and the banking system.

There has long been a marked distinction between economists who study finance and economists who study the broader economy, with limited communication between the groups. As a young Harvard University economist, Mr. Summers argued this was a dangerous shortcoming in a now famous screed, where he unfavorably compared finance specialists to “ketchup economists” who are too narrowly focused on their field of study, while also complaining about general economists tendency to continually rediscover conclusions that the finance specialists had come to long ago.

Finally, many academic economists privately worried that a housing bubble was building, and that it’s bursting would cause severe problems, but didn’t publicize their concerns. An exception is New York University’s Nouriel Roubini, who in 2006 said that the U.S. was almost certainly heading into a recession. Mr. Roubini is often characterized as a grand stander, but Mr. Rajan says that he deserves credit for acting on his convictions.

“Most academics are really reluctant to take part in the public dialog, because the public dialog requires you to have an opinion about things you can’t really be sure about,” says Mr. Rajan. “They fear talking about things where everything is not neatly nailed in a model. They stay away and let the charlatans occupy the high ground.” – Justin Lahart

While it is clear that the free market systems provide better overall results when compared to government run financial systems, it assumes the existence of free markets. That doesn't just mean no government interference. It means that information needs to flow freely and not be suppressed.

A free flow of information is opposed by bankers, often for good operational reasons over and above just the additional cost of collecting it. But a lot of data has to be available about the overall system, and to get that will require government collection and publication. That means regulation, such as that supposedly provided by the SEC. That's why the SEC is ultimately responsible for supervising, collecting and reporting financial information in corporate financial reports, for example. Without that regulation, each company would collect and report what it wanted to in whatever way it desired. Comparison between companies would be impossible. Standardization and enforcement of honest reporting are a clear government function. That's not government interference with the free market. It's government support for it by keeping data available so that it can do what it is supposed to do - flexibly provide the goods and services demanded by consumers and businesses and properly asses the risk that the bankers are taking making loans.

There are good arguments for getting government involved in the financial system other than just being there to try to pick up the pieces when it fails. It certainly has not been there enough for the last thirty years.