Charles Wheelan, Ph.D. The Naked Economist

I have one more item of bad news related to the mortgage meltdown: It'll likely provide lots of ammunition for advocates of more government regulation, in the mortgage industry and everywhere else. I'm afraid we're getting what we deserve.

Three things have become clear as the mortgage/real estate debacle has unfolded: 1) Left to their own devices, millions of people (and some pretty sophisticated lenders and investment banks) will do some profoundly stupid things; 2) The effects of those stupid things spill over to affect everyone else; 3) Lots of Americans expect their government to do something about it. (Let's not pretend that it's just Democrats; the White House was pretty darn quick to roll out its bailout plan.)

Rational Debate

One of the fundamental debates within economics concerns the degree to which individuals make fully rational decisions. Do people always act in their own best interest? Or can government help prevent them from doing things that they'll later regret?

This debate over "rational man" isn't just academic -- it lies at the heart of what government ought to do. Should government treat its citizens as informed adults or semi-rational adolescents?

Milton Friedman was the most articulate and prominent proponent of the belief that individuals always act in their own best interest. Yes, it may be dangerous to ride a motorcycle without a helmet, but rational individuals can and should decide whether the thrill of riding without a helmet outweighs the risk of becoming an organ donor.

You Know Best

Individuals know best, Friedman argued brilliantly, even when their decisions don't always make sense on the surface. A worker who takes out a payday loan at an annualized interest rate of 800 percent presumably doesn't have a better option. The same goes for the sweatshop employee in Bangladesh who's willing to work long hours for a few dollars a day. Who are we to say that's a bad decision? Have any of us ever been a poor Bangladeshi peasant?

Even worse, when government overrides individual decisions, then self-serving bureaucrats carve out power and perquisites for themselves. And the larger the public trough, the more incentive organized interests have to jostle for a spot.

The corollary to that view, of course, is that when individuals or firms do stupid things, we ought to let them wallow in their own mistakes. For Friedman and his acolytes, society is best off with a small government that leaves individuals unconstrained to make their own decisions, for better or worse.

Saving Us from Ourselves

Ah, if it were only that easy. There's an equally compelling argument, with strong supporting evidence, that individuals make systematic errors of judgment, and that we're bad at assessing risk. Thus we obsess about dying in a terrorist attack as we merrily tool around the suburbs in our cars -- the latter of which is far more likely to kill us.

We discount the future too heavily. Thus we eat poorly and exercise too little, only to suffer from Type 2 diabetes later in life. Or we start smoking because we think we can quit -- and we don't.

Investors make portfolio decisions that defy the basic rules of finance and lose a bundle as a result. After the dotcom collapse, the Wall Street Journal ran a series of articles on individuals who had taken their retirement savings as a lump sum and then lost most or all of it chasing Internet stocks. The articles were so depressing that I couldn't read them after a while.

All these examples suggest that government can help save individuals from themselves. Cigarette taxes not only compensate society for smokers' health care costs, they may also deter some potential smokers from taking up the habit in the first place. And limiting the portfolio choices investors can make with their IRAs or 529 college savings accounts might stop them from investing a chunk of money in the Harrah's Roulette Fund.

A Bad-Judgment Pileup

Which brings us to the real estate debacle. We now expect roughly a million mortgages to go into default, despite the fact that there's nothing about the real estate correction that should come as a great shock.

No one could've predicted exactly when or by how much real estate prices were going to fall. In fact, no one could have said with certainty that they would fall at all. But any rational person should've known that it was a realistic possibility.

And given that it was a realistic possibility, homeowners shouldn't have borrowed more than their homes were worth. Banks shouldn't have made adjustable rate loans to anyone who could prove that they were alive. And the greatest minds on Wall Street shouldn't have bundled and sold mortgages without clarifying exactly who would be on the hook if lots of them went into default. But that's what happened, because prices were going up, up, up! This all strikes me as a load of new evidence for the "government for semi-rational adolescents" camp.

Pick a Side

But there's a second reason that we're probably not ready for Friedman's elegant small government: When people who play with matches burn their houses down, we're generally not pleased if our political leaders pull up lawn chairs and watch the flames. We expect them to do something about it. We want a plan.

Have you heard any presidential candidate from either party explain why the appropriate response to the mortgage debacle is to let the culpable parties pay the price for their mistakes? Nothing teaches you about debt like losing your home to foreclosure. I'm still waiting for that speech. (OK, Ron Paul has probably given it -- which is one reason he'll never get more than 10 percent of the vote.)

Everyone loves small government in theory. We're tired of being told that the coffee we're about to enjoy is hot. But then we burn ourselves and expect someone to show up with ice. You can't have it both ways.