This column was prompted by the question: “Doesn’t today’s economic distress demolish the case for capitalism and free markets?”

Some, who inquired gleefully, anticipated my discomfort; others were genuinely curious and concerned. All were confused about the complex causes of our economic chaos.

I hope this helps clarify their thinking, but first a disclaimer: I’m not a general economist who knows macroeconomics, money and banking, and international trade. Rather, I’m a retired professor and farmer who has studied and written academic articles and books on political economy for 40 years. I focus on the ways in which institutions, that is culture, ethical norms, and law, influence wealth, opportunities, and strategic behavior.

Let’s dismiss the claim that the greed of Wall Street and investment bankers caused our distress. Greed is ubiquitous, perhaps for evolutionary reasons. Jewish theologians have wrestled with this character flaw for three thousand years. Yet, Israeli politics remain plagued with pathological greed.

Blaming greed is like condemning gravity; both endure. Responsible people recognize and utilize these forces rather than deny them. It’s most constructive to design institutions that contain and direct greed into productive channels, just as engineers put gravity to use in building arches. Obviously, our institutions are flawed, greed has run amuck, and innocent as well as complicit folks are hurt.

Let’s first consider the basic function of capitalism. Its success lies in efficiently allocating capital toward profit, the difference between costs and returns. When the system works, market prices provide the information and the incentives to invest where legal returns are greatest.

But this is perhaps not capitalism’s greatest asset. In addition to being an engine of prosperity, only free markets spontaneously and peacefully organize the daily, voluntary interactions of millions of primarily self-interested individuals.

Socialism works poorly because it is unable to efficiently coordinate and allocate resources. Hence, it never generates wealth for the masses—but socialist elites enjoy privilege and plenty. Their greed rigs the game to their advantage. Likewise, America’s investment bankers have rented and bribed politicians to rig the game to socialize risks and privatize profits. Fannie and Freddie’s failures and rich rewards to former managers, $100 million to one, are prime examples.

Our current problems flow largely from Wall Street bankers’ financial innovations. They discovered ways to profit by misallocating capital, and in the process they decoupled risk from their returns. Under legislation for which they lobbied, they were rewarded for pumping evermore capital into overvalued housing. Viewing their houses as ATMs, people bought consumer goods far beyond their means. (Expect massive credit card default next.)

Investment bankers arranged highly arcane financial instruments covering their loans with understated risks. Loans were bundled, sold internationally, and insured by American International Group (just bailed out with nearly $125 billion from the federal government) among others. This process endured as poor risk management was fostered by profits from capital misallocation.

Further, Wall Street adults who should have been in charge and responsible, didn’t understand the complex, mathematical models directing investment decisions. Senior management ignored the admonition to loan money only to those likely to pay it back.

While some bankers knew better, the net result of bad loans is the erosion of capital. Assuming recovery, we need institutional reforms that inhibit capital misallocation. For example, removing legal requirements to make loans when risks are not reflected in interest rates. This generates loss while stressing people, especially the poor.

When politicians allocate capital, we can’t expect efficiency, but corruption by special interests is certain. Investment banks benefited from this political arrangement. With the Bush Administration encouraging sub-prime lending (the “Ownership Society”), these home loans grew from 2 percent in 2002 to 30 percent in 2006. In October of 2004, President Bush said, “We're creating…an ownership society in this country, where more Americans than ever will be able to open up their door where they live and say, welcome to my house, welcome to my piece of property.”

Sub-prime loans were bundled into Collateralized Debt Obligations and rated AAA. With this high rating, investment-banking firms neglected due diligence and sold the bundles worldwide. Defaults and massive write-offs naturally followed, banks collapsed, and we suffer.

That’s what went wrong.