In my view, what we are seeing today is the unwinding of multiple bubbles, starting with the stock market bubble in the late 90s, the housing bubble of the mid-2000s, and the most recent mini-bubble in commodities. These bubbles all have a common source, which was lax monetary policy coming out of central banks. These lax policies were meant to cushion the impact of multiple crises, starting with the crisis in 1998 that arose from the Russian default and the plunge in Asian markets through 9/11. Banking authorities, most notably Alan Greenspan, thought they had inflation under control because consumer price inflation was under control (thanks, largely, to the huge boon to consumers of globalization; consider all the unbelievably cheap “made in China” products on the shelves), and came up with all sorts of rationalizations as to why ASSET price inflation was not really inflation. The incompetence of the relevant authorities in understanding asset price inflation is demonstrated by the fact that Greenspan bought into the idea that housing prices wouldn’t fall nationwide because they never had before–forgetting that the underlying increase in housing prices was itself unprecedented. Greenspan obviously believed, against all relevant historical data, that the run up in prices was a natural result of market forces.
In short, we can argue from here to eternity over exactly what pro-free market or pro-regulatory U.S. government policies precipitated the crisis as it specifically developed. But if I’m right that the underlying problem was overly lax monetary policy, which sent false signals to the market regarding the true price/value of money and the amount of real wealth that was being created, it seems to me that even if financial sector/housing policy had been infinitely wise, the bubble would have developed in another sector where policy was less wise, and would have also caused serious economic dislocation when it popped.
Keep in mind also that putting aside all of the debate about what the Bush Administration, Congress, Clinton, et al., did or did not do, the housing bubble was not an American phenomenon, but was as bad or worse in various parts of Western Europe, Eastern Europe, and Asia, which, I’m guessing, have about as broad a range of regulatory policies regarding both housing and finance as one can reasonably expect. The prior stock market bubble was also a worldwide phenomenon, as was, of course, the commodities mini-bubble. This again suggests that the problem was a worldwide misapprehension by central bankers of the consequences of their actions, and not some specific pro or anti free market policies pursued by the U.S. government (not to say that wiser policies couldn’t have helped mitigate the damage at some point, especially by cracking down on leverage when there was still time, one of the apparently forgotten lessons of the Great Depression…)
As Eric Posner suggests below, the pure libertarian solution–a free market in money, with no central bank intervention–is not even on the table among “serious thinkers.”
And I’m not even going to argue that the pure libertarian solution is the right one. But if the blame is accurately placed primarily on central bank policy, then it’s rather foolish to consider this a failure of libertarianism or free markets.
It is, on the other hand, an example of the failure of a particular libertarian, Alan Greenspan. Somehow, perhaps for ideological/psychological reasons, he appears to have seen himself as a champion of an anti-regulatory ideology, even though he was the most powerful regulator in the world, and was artificially reducing the cost of money. It would be hard for even the best satirist to come up with a figure like Greenspan, an objectivist who wielded more government power over the economy than any other individual in the world, used that power incompetently, and then allowed himself to believe (at least twice) that bubbles that his policies helped create were the result of the “free market” and needed to be left alone.
UPDATE: One more thought. Libertarians of the utilitarian school often oppose government regulation not because they think that all government regulation is inherently illegitimate, or even necessarily bad, but because on balance they think that decisions made through the political process, or by regulators (like Greenspan) acting with limited information, are likely in most cases to be less sound than decisions made through decentralized market processes. It seems to me that many of the bad decisions made, both on the pro (Fannie, Freddie, Community Reinvestment Act, etc.) and anti (failure to regulate derivatives, leverage, etc.) were not the result of any particular ideology, but the natural result of the political process. One problem with the inevitable “mixed economy” that we live in, and which libertarians would predict, is that the political process will often give us the worst possible result–privatization of profit, socialization of risk.