[the editorial in this week's Economist warns of "home rage" but says
that all those animal spirits are good for the economy, finance=god
("a brain for matching labour to capital"), and regulators will never
catch up, ruining everything if they try to live out their "fantasy."
Sad capitalists need to get a pair: nothing has changed, everything
has been the same since time began (c. 16th century) Nothing, really,
needs to be done. The bubble has burst! Long live the bubble! Old
wine/bottles; War = peace; freedom=slavery; 2+2=5, etc. In short, be
reactionary before the radicals get any purchase on the narrative. -s]
http://www.economist.com/opinion/displaystory.cfm?story_id=10966204
Fixing finance
Apr 3rd 2008
From The Economist print edition
Crises are endemic to financial systems. Attempts to regulate them may
do more harm than good
AS IF collapsing prices were not enough, American mortgage firms now
have to cope with home rage. Borrowers vent their fury on the system
that is repossessing their properties by smashing holes in walls and
tipping paint over living-room carpets. Something similar is going on
in the house finance built. Faith in open markets has been poisoned by
a crisis that has spread from one asset to the next. First there was
disbelief and denial. Then fear. Now comes anger.
For three decades, public policy has been dominated by the power of
markets—flexible and resilient, harnessing self-interest for the
public good, and better than any planner-in-chief. Nowhere are markets
deeper and more liquid than in modern finance. But finance has
stumbled and there are growing calls from all sides for bold
re-regulation.
New rules became inevitable the moment the Federal Reserve rescued
Bear Stearns and pledged to lend to other Wall Street banks. If
taxpayers are required to bail out investment banks, the governments
need to impose tighter limits on the risks those banks can take. This
week Hank Paulson, America's treasury secretary, unveiled a
longer-term plan to deal with this and other weaknesses in America's
regulatory system (see article); and next week the G7 finance
ministers will meet in Washington, DC, where they will discuss a
report on the crisis by the Financial Stability Forum.
It is natural and right that regulators should seek to learn lessons.
The credit crisis will damage not just the reputation of the financial
system but also the lives of those who lose their houses, businesses
and jobs as a result of it. But before governments set about reforming
financial regulation, they need both to be clear about the causes of
the crisis and to understand just how little regulators can achieve.
Arm's-length finance
The history of financial markets is not a stable one. They have
imploded every decade or so, whether because French and Spanish kings
reneged on their debt in the 16th century or because speculators
inflated railway stock in the 19th century. But this crisis is
unusually shocking, if only because the mild business cycle and the
fast pace of world economic growth in recent years had lulled people
into a false sense of security.
The view that the only sensible response to the 21st century's first
serious financial crisis is a wholesale reform of the system is now
gaining ground. Josef Ackermann, über-capitalist and chief executive
of Deutsche Bank, summed it up in a call for governments to step in:
"I no longer believe in the market's self-healing power." The
implication is that, if the market cannot heal the wounds it sustains
as a result of its own risky behaviour, then it must be discouraged
from taking such risks in the first place.
But there are two reasons to hesitate before plunging headlong into a
purge of the system. First, finance was not solely to blame for the
crisis. Lax monetary policy also played a starring role. Low interest
rates boosted the prices of assets, especially of housing, which in
turn fed into complex debt securities. This created a spiral of debt
that is only now being unwound. True, monetary policy is too blunt a
tool to manage asset prices with, but, as the IMF now says, central
banks in economies with deep mortgage markets should in future lean
against the wind when house prices are rising fast.
The second reason to hesitate is that bold re-regulation could damage
the very economies it is designed to protect. At times like this, the
temptation is for tighter controls to rein in risk-takers, so that
those regular, painful crashes could be avoided. It is an honourable
aim, but a mistaken one.
The inevitable crash
Finance is a brain for matching labour to capital, for allowing savers
and borrowers to defer consumption or bring it forward, for enabling
people to share, and trade, risks. The smarter the system is, the
better it will do that. A poorly functioning system will back wasteful
schemes and shun worthy ones, trap people in the present, heap risk on
them and slow economic growth. This puts finance in a dilemma. A
sophisticated and innovative financial system is susceptible to
destructive booms; but a simple, tightly regulated one will condemn an
economy to grow slowly.
The tempting answer is to try to wriggle free from the dilemma with a
compromise that would permit innovation but exert just enough control
to squeeze out financial failure. It is a nice idea; but it is a
fantasy. The experience of the past year is an object lesson in the
limited power of regulators.
Just look at their mistakes. Before the crisis, hedge funds were
regarded with suspicion as vulnerable and irresponsible. But, with a
few notable exceptions, they have weathered the storm less as culprits
than as victims. Instead, the system's own safety features turned out
to be its weakest points. The copper bottom fell out of AAA bonds when
housing markets failed to do what the rating agencies had expected.
Banks avoided rules requiring them to put aside capital, by
warehousing vast sums off-balance sheet with disastrous results.
It would be convenient to blame the regulators for all that, but the
system is stacked against them. They are paid less than those they
oversee. They know less, they may be less able, they think like the
financial herd, and they are shackled by politics. In an open economy,
business can escape a regulatory squeeze in one country by skipping
offshore. Once a bubble is inflating many factors conspire to
discourage a regulator from pricking it.
And even if you could put all that right, regulators would still fail,
because of the nature of finance itself. Financial progress is about
learning to deal with strangers in more complex ways. The village
moneylender, limited by his need to know those he did business with,
was gradually superseded by ever-broader impersonal markets that can
cheaply mobilise colossal sums and sell more complex products. The
remarkable thing is not that finance suffers from booms and busts, but
that it works at all. People who would not dream of lending £1,000 to
that nice family three doors down routinely hand over their life
savings to strangers in a South Korean chaebol or an Atlantan
start-up. It all depends on trust.
Regulators cannot know how trust will ebb and flow as new markets
develop the experience and practice they need to work better. They
therefore cannot predict the peril of new ideas. They have to let new
markets develop, or stifle them. The system learns—dangerous junk
bonds are reborn as respectable high-yield debt; bankers will now be
scared of extreme leverage—but it is delicate, as the world learned
last summer. The regulator is condemned to muddle through.
The notion that the world can just regulate its way out of crises is
thus an illusion. Rather, crisis is the price of innovation, so
governments face a choice. They can embrace new financial ideas by
keeping markets open. Regulation will be light, but there will be
busts. The state will sometimes have to clear up and regulation must
be about cure as well as prevention. Or governments can aim for safety
and opt for dumbed-down financial systems that hobble their economies
and deprive their people of the benefits of faster growth. And even
then a crisis may strike.
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