The problem with the financial crisis wasn't that big business was too free from governance – it was the opposite. Or so says the Republican party, which is pulling off a remarkable confidence trick that could yet swing this year's presidential election

Here are the two contradictory facts you must keep in your mind if you wish to understand American politics today:

1. We are entering the fifth year of a profound economic slump that was brought on, in large part, by our government's failure adequately to supervise financial institutions – a matter of deliberate national policy that was justified over the years by the familiar neoliberal faith that market forces would cause financial institutions to regulate themselves.

2. The main political effect of this slump has been the strengthening of the right wing of the Republican Party, with its doctrinaire insistence on further deregulation; in fact, of the various Republicans who have a realistic shot at the presidency, each one has publicly declared that regulation is one of the greatest evils facing the nation and has sworn to liberate banks and financial institutions from government supervision.

Now, maybe you are one of those inclined to dismiss Republican politicians as preening hypocrites whose moral posturing is possible only thanks to their followers' apparent separation from reality. And once you get over their absurdity, it occurs to you that they are also dangerous. Their ideas, if implemented, would crash the economy, wreck the regulatory state, exacerbate the already outrageous gap between the rich and everybody else. This can't be happening, you conclude. These people can't possibly win. But of course this is what's happening, and there's a very good chance that in this year's election, one of these Republicans will be chosen to be the next president of the US.

Bank deregulation was, for decades, the consensus wisdom of both American political parties. Visionary, tech-friendly Democrats joined with stern, patriarchal Republicans to circumvent the country's banking rules and to mute its supervisory agencies. In the noblest spirit of bipartisanship, they either repealed basic banking laws outright or took steps to ensure that such laws were no longer enforced. Self-interest is what would make bankers play fairly and oil companies drill safely.

Under the guidance of this doctrine, America's leaders exempted certain derivatives from regulatory oversight; they watered down requirements that banks balance their risk with safe assets; they overruled state-level predatory lending laws; they exempted credit default swaps from regulation as insurance products and they dialled back the Federal Reserve's regulatory powers.

In 2008, it all went wrong. The country's financial system suffered an epic breakdown, largely the result – as nearly every serious observer agrees – of the decades-long effort to roll back bank supervision and encourage financial experimentation. Unregulated lenders, we now know, pushed millions of Americans into home loans they could not afford. Much-deregulated investment banks packaged those lousy loans up into investments that the nation's ratings agencies promptly declared to be of the first quality. Insurance companies issued totally unregulated financial instruments against the possibility that these crappy investments would ever fail. And when the real-estate bubble inevitably burst, all of it plunged the nation and the world into the worst recession since the 1930s.

The reaction to these excesses was the feeble Dodd-Frank act that Congress passed in 2010, which is supposed to prevent some of the more outrageous financial misbehaviour of the last few years. And the reaction to that is the great crusade against the very idea of regulation that is presently burning its way back and forth across the early-voting states of Iowa and New Hampshire, whose elections began this month. It has suddenly dawned on Republican leaders that government supervision of the economy is a liberty-strangling imposition.

And so, almost exactly three years after the meltdown of the stock market in 2008, former Massachusetts governor Mitt Romney, the man who may well be our next president, saw fit to blame virtually the entire business slump on Dodd-Frank – it "kills the economy", he intoned. Representative Michele Bachmann, the Pasionaria of the small-business way, frequently reminded the voters of Iowa that she made the first attempt to repeal the hated Dodd-Frank law. "Our biggest problem right now," she has also declared, "is our regulatory burden." Texas governor Rick Perry agrees: "It's the regulatory world that is killing America," he told a debate audience in November (the transcript tells us that this line was greeted with "applause"). Perry's fellow Texan, representative Ron Paul, tells us we need to repeal not only Dodd-Frank but also the feeble regulatory law enacted in the wake of the Enron disaster a decade ago. Rick Santorum, former senator of Pennsylvania, has informed the nation, "I'm going to repeal every single Obama-era regulation that costs business over a hundred million dollars. Repeal them all." So intolerable is it that former speaker of the house Newt Gingrich suggests that we need to put the bill's authors – Christopher Dodd and Barney Frank – in prison.

Set those markets free – the 'true believers' (from top left): Mitt Romney; Newt Gingrich; Michelle Bachmann; Ron Paul; Glenn beck; Rick Perry. Photographs: AP (2); Getty (2); Reuters; AFP/Getty

To rage so violently against financial supervision is, admittedly, a peculiar way of responding to a severe downturn brought on by a largely unsupervised financial sector. It is not how Americans reacted in the past. Up until now, the social patterns of hard times were thought to be a simple thing, as impersonal and as mechanical as the forces that shutter our factories and bid down the price of our stocks. Markets disintegrate, layoffs mount, foreclosures begin, and before you know it, the people are in the streets, screaming for blood. We grow desperate, anxious, rebellious. We demand that the government do something about it – that they punish the perps, that they rescue the victims. We look for insurance against further catastrophe, and stricter regulation of the economy, to make sure it doesn't happen again.

But that's not what happened in 2009 and 2010. What we saw is something unique in the history of American social movements: a mass conversion to free-market theory as a response to hard times. Before this recession, people who had been cheated by bankers almost never took that occasion to demand that bankers be freed from "red tape" and the scrutiny of the law. Before 2009, the man in the bread line did not ordinarily weep for the man lounging on his yacht.

The achievement is even more remarkable when we remember the prevailing opinion-climate of 2008. After the disasters of the George W Bush presidency had culminated in the catastrophe on Wall Street, the citizens of Beltway consensus-land all agreed upon the direction in which the nation was travelling. Conservatism's decades-long reign was at an end. An era of leftwing activism was at hand. The thinking behind all this was straight cause-and-effect stuff. The 2008 financial crisis had clearly discredited the conservative movement's signature ideas; political scandal and incompetence had wrecked its ethical claims; and conservatism's taste for strident rhetoric was supposedly repugnant to a new generation of post-partisan voters. Besides, there was the obvious historical analogy that one encountered everywhere in 2008: we had just been through an uncanny replay of the financial disaster of 1929-1931, and now, murmured the pundits, the automatic left turn of 1932 was at hand, with the part of Franklin Roosevelt played by the newly elected Barack Obama.

All of this was reasonable enough if you accepted assumptions that were thought to be obvious in those days: when a political group screwed up, people didn't vote for it any longer. When elected officials wandered too far into the fields of ideology, some mysterious force of political gravity always pulled them back to the "centre". The right, under its beloved and calculating leader, George Bush, had disgraced itself; now it was the other team's turn to bat. There were supposed to be 30-year cycles for political epochs, and the Republicans' 30 years were up. That they might seek a way out of their predicament by turning their back on the centre and peddling an even more concentrated version of their creed was not, by the conventional thinking of those innocent days, a viable option.

But, as it turned out, the direction the parties moved was less important than how they explained the catastrophes facing the nation. And conservative Republicans had an explanation. Everywhere you looked, they declared, you saw a colossal struggle between average people and the "elites" who would strip away our freedoms. The huge bailouts that followed the financial crisis, they said, were evidence of a design on our savings by both government and Wall Street. Regulation, too, was merely a conspiracy of the big guys against the little.

Rather than acknowledge that they had enjoyed 30 years behind the wheel, they declared that they had never really had their turn in the first place. The true believers had never actually been in charge, the market had never truly been free, and therefore the disastrous events of recent years cast no discredit on conservative ideas themselves. The solution wasn't to reconsider deregulation; it was to double down, to work even more energetically for the laissez-faire utopia.

Pure idealism of this sort is unusual in American politics, however, and the jaded men of the commentariat sat back and waited for the system to punish the wayward ones, for the magnetic pull of the "centre" to work its corrective magic. But this time the gods didn't intervene in the usual way. In 2010, a radicalised Republican party scored its greatest victory in congressional elections in many decades. In the House of Representatives, an amazing 63 seats changed from blue to red. It had been only two years since Barack Obama's own great victory, but now the populist fury was all on the other side.

The story was the same across the country. Liberals were wiped out, and the rightmost reaches of the Republican party rode to triumph. National Journal went through the exit polls in January 2011 and discovered that, nationwide, blue-collar whites chose Republican congressional candidates by an amazing margin of two to one. In a demonstration of "profound resistance to Obama and his agenda", the demographic that had been moved by capitalism's last systemic crisis to hand the presidency to Franklin Roosevelt four times in a row now resurrected the politics of Herbert Hoover.

How did the traditional views of the great bankers become the rallying cries of a populist revolt – a populist revolt ignited by the outrageous misbehaviour of said bankers? Well, by focusing not on the decade of folly preceding the collapse, but on the culminating event of the financial crisis: the bank bailouts of 2008 and 2009. No one seemed to know what credit default swaps were, but these bailouts were a villainy Americans could understand. They would be costlier, Americans were told, than the entire Vietnam War, or the Louisiana Purchase, or just about anything else. And they were unmistakably bad: the bailouts were the avenue by which our government obligingly moved the financial industry's losses over to the taxpayers.

In different times, the bank bailouts might have become the rallying-point of a revitalised left. After all, the bailouts were clearly of a piece with the misbehaviour that had come before: the deregulation of the banks, the bonus culture, the wrecking of the supervisory state. Business-friendly conservatives had been behind each of these, and then business-friendly conservatives had knitted together the bailout bill for the same rotten reason: to give the bankers whatever they wanted. Reformers might have depicted the bailouts as the final chapter in the great book of fraud, the episode in which Wall Street used the captured state to transfer its debts to the public.

But of course they didn't. Democrats did the bidding of the Bush administration and passed the bailout bill, and then Obama obligingly continued Bush's bailout policies without interruption. This was supposed to be statesmanship, but it also allowed the right to grab the opportunity to define the debate, using bailouts to shift the burden of villainy from Wall Street to government. For them, the bailouts were the only part of the crisis story that mattered – not the derivatives or the deregulation – and its conservative-Republican parentage made no difference.

For this sleight of hand to work, conservatives had to surmount an enormous cognitive barrier. By and large, the people who designed the hated bailouts – and the banks that benefited from them – had played on the conservative team. It was no problem to cast the Democrat Obama as a freedom-crushing dictator. But what to make of the fact that the ones who hustled the nation into this state of tyrannical un-freedom were, a few short years ago, free-market paladins themselves?

For the conservatives of 2008 and 2009, that left only one possibility: to swerve farther rightward and declare that the previous generation of conservatives had never really been true free marketeers at all. They even excommunicated their old hero, George Bush, as a traitor to the cause of freedom. Bush helped matters along by confessing that, "I've abandoned free-market principles to save the free-market system", a line that will forever live in infamy on the websites of the insurgent right.

And thus did free-market disaster give rise to a bitter but utopian faith in free markets. A particularly telling expression of the new attitude can be found in a 2009 pamphlet called Spread This Wealth. In order to teach readers about the nature of capitalism, author C Jesse Duke, who also sells a Tea Party flag of his own design, follows the doings of an imaginary primitive man who finds a stick, kills a deer, and trades things with other primitive men. Mr Duke then makes this pronouncement: this whole process of free markets and the trading of time and energy is just the natural order of the world. A tree exchanges oxygen for carbon dioxide. A fire exchanges heat for oxygen. Atoms exchange electrons to become other atoms. Plants collect light to make chlorophyll, which nourishes animals, which become food for other animals and man, and so on. Everything in nature is constantly exchanging. So the free exchange of time and energy between people is the God-designed, natural order. Conflicts erupt when this order is upset.

Remember the larger situation in which Duke felt moved to pen these remarkable words. Our economy was in ruins thanks to complex, unregulated financial derivatives. Monopolies and oligopolies were everywhere. Hourly wages had been falling for decades. But according to this voice of protest, the way to make sense out of it all was by imagining a state of economic nature. By presuming that God Himself wants government to stay out of it.

That we don't have pure capitalism in America is not a revelation vouchsafed to the great Tea Party awakening. For decades, the idea has been a staple of the left, where the limited-capitalist model is generally understood as a good thing. The state is involved in the economy all right, the libs say, but that's because it has to be. A complete free market would be a disaster, something not even the business community itself wants to try. The real problem, from the liberal perspective, is that government doesn't go far enough – it merely doles out public subsidies of one kind or another while shareholders of private companies walk off with the profits, in the now familiar scenario of socialised risk and privatised gain.

The revitalised right simply turned this argument upside down. Yes, government had its finger in every segment of the economy, and that's what was to blame for everything that had happened. Market forces had never been truly free, and therefore they bore none of the blame for our current predicament. And so the obvious answer arose from a thousand megaphones: get government out of the picture completely. Until the day free enterprise was totally unleashed, capitalism itself could be held responsible for nothing.

In order for markets to deliver us to our destiny, we had to become mindful of their freedom. And ordinary people by the millions heard the call. In October 2010, the populist TV personality Glenn Beck exhorted his host of alienated followers to donate money to the US Chamber of Commerce – the biggest, baddest business lobby in all of Washington, DC – on the grounds that "they are us". Ordinarily, of course, gifts to the Chamber are denominated in the hundreds of thousands and are made by enormous corporations, but such a deluge of small donations followed Beck's appeal that it crashed the Chamber's servers.

And thus are our choices spread before us. On the one hand, "socialism"; on the other, the laissez-faire utopia. One system is "capitalism", the "American Way of Life"; it is in harmony with the rhythms of nature itself; but the other is something alien, something impure, something dishonest – and something that props up Wall Street banks when they should rightfully have failed.

Taking this tack has allowed the renaissance right to do a very remarkable thing: to pretend to be an enemy of big business, on the grounds that big business is insufficiently capitalist. This was the point of an amazing 2009 essay in Forbes magazine penned by Congressman Paul Ryan and entitled, Down With Big Business. The giant corporation, Ryan wrote, could not be counted upon to defend capitalism in its hour of need: "It's up to the American people – innovators and entrepreneurs, small business owners… to take a stand."

And take a stand they have done. From a thousand Tea Party gatherings, the revitalised right learned to mimic the historical left. At FreedomWorks, the influential free-market pressure group run by former House Majority Leader Dick Armey, there is reportedly a deliberate effort to look and sound like a leftwing organisation. Activists that the group trains are asked to learn the leadership secrets of the Communist party and to read a book by the famous neighbourhood organiser Saul Alinsky; their idea for a big march on Washington came to them from another favourite text: a famous history of non-violent protest. To fill the streets with demonstrators rallying for free markets – why, according to Armey, "In Washington, DC, this is known as radical. Even dangerous." It is so radical, so dangerous that "the establishment doesn't like it one bit".

On the surface, the newest right sounds remarkably like the old, old left. The most extraordinary pseudo-populist enterprise has been that of the aforementioned rightwing TV entertainer Glenn Beck. In 2009 he launched what he called the "9-12 Project" with a tribute to the "forgotten man" (a favourite phrase of the Depression-era left) and an invitation to meet people from "all across the country" – that is, "regular people like you". The movement was to be a thing of local chapters, mass rallies, mosaics made up of thousands of snapshots, and saccharine talk about how capitalist salvation lay somehow in the collective – that when angry citizens got together to revel in their Americanness, they would no longer "feel powerless". The proposal soon went from all-American solidarity to a dark vision of the insiders who are manipulating us: once you pull away the curtain, you realise that there are only a few people pressing the buttons, and their voices are weak. The truth is that they don't surround us at all. We surround them.

It was a powerful invocation of the archetypal 30s image: the masses; the righteous millions; the people. Once again Americans were marching for liberty; once again they had their eye on a utopian economic scheme. But this time we had set off in entirely the wrong direction.

• This is an edited extract from Pity The Billionaire, by Thomas Frank, to be published on 26 January by Harvill Secker at £14.99. To order a copy for £11.99 (including UK mainland p&p), go to guardian.co.uk/bookshop.