SYNOPSIS: Switching to free markets without adequate study is a recipe for failure. Power failure, that is.

California's deregulated power industry, in which producers can sell electricity for whatever the traffic will bear, was supposed to deliver cheaper, cleaner power. But instead the state faces an electricity shortage so severe that the governor has turned off the lights on the official Christmas tree — a shortage that has proved highly profitable to power companies, and raised suspicions of market manipulation.

The experience raises questions about deregulation. And more broadly, it is a warning about the dangers of placing blind faith in markets.

True, part of California's problem is an unexpected surge in electricity demand, the byproduct of a booming economy. It's possible that the crisis would have happened even without deregulation.

But probably not. In the bad old days, monopolistic power companies were guaranteed a good profit even if their industry had excess capacity. So they built more capacity than they needed, enough to meet even unexpectedly high demand. But in the deregulated market, where prices fluctuate constantly, companies knew that if they overinvested, prices and profits would plunge. So they were reluctant to build new plants — which is why unexpectedly strong demand has led to shortages and soaring prices.

Now you could say that in the long run there is nothing wrong with that. Building extra generating capacity was costly, and the costs were passed on to consumers; while prices may fluctuate in a system with less slack, on average consumers will pay less. In fact, textbook economics suggests that it's actually a good thing that electricity prices skyrocket when supply runs short: that's what gives the power companies an incentive to invest. And so you could argue that no public intervention is warranted — indeed, that the caps that still place an upper limit on electricity prices only worsen the problem, that we should rely on market competition to solve the crisis.

But how competitive is the electricity market? What makes California's power crisis politically explosive is the suspicion that it's not just about inadequate capacity, but also about artificially inflated prices.

How might market manipulation work? Suppose that it's a hot July, with air-conditioners across the state running full blast and the power industry near the limits of its capacity. If some of that capacity suddenly went off line for whatever reason, the resulting shortage would send wholesale electricity prices sky high. So a large producer could actually increase its profits by inventing technical problems that shut down some of its generators, thereby driving up the price it gets on its remaining output.

Does this really happen? A recent National Bureau of Economic Research working paper by Severin Borenstein, James Bushnell and Frank Wolak cites evidence that exactly this kind of market manipulation took place in Britain before 1996 and in California during the summers of 1998 and 1999.

You wouldn't normally expect this to happen in colder months, when demand is lower. Still, state officials have understandably become suspicious about California's current power emergency — an emergency precipitated by the odd fact that about a quarter of the state's generating capacity is off line as the result of either scheduled repairs or breakdowns.

Maybe California power companies aren't rigging electricity prices. But they clearly have both the means and the incentive to do so — and you have to wonder why the deregulators didn't worry about this, why they didn't ask seemingly obvious questions about whether the market they proposed to create would really work as advertised.

And maybe that is the broader lesson of the debacle: Don't rush into a market solution when there are serious questions about whether the market will work. Both economic analysis and British experience should have rung warning bells about California's deregulation scheme; but those warnings were ignored — just as similar warnings are being ignored by enthusiasts for market solutions for everything from prescription drug coverage to education.

Originally published in The New York Times, 12.10.00