Speaking from middle of the financial storm, voices are raised blaming the tumult on the speculators, on the banks, on the hedgies, on the shorts, on the Republicans, on the ratings agencies, on the Democrats’ Community Reinvestment Act, on CDO’s and CDS’s, on people buying houses above their station, you name it. This is all at one level right, but that level doesn’t matter. The system, by definition, will always contain a measure of knaves and fools, because it’s populated by instances of homo sapiens. Thus, it has to be regulated to keep it running. Thus, the current meltdown is a failure of regulation and nothing else. The long term solution has to be about regulation too.
Free Markets · The evidence from history seems pretty clear; if what you want is an increase prosperity and decrease in poverty, free markets are the way to go. This doesn’t mean that the markets are an end in themselves, they are an economic tool. It doesn’t mean they are “natural” either; across the course of history a huge proportion of humans have lived in tyrannies of one sort or another in which nothing, including the market, was free.
And finally, it doesn’t mean that they’re self-sustaining. Any economics undergrad can explain why banks, which by definition borrow short and lend long, absolutely must be regulated, and backed with public-sector insurance, if they’re going to be viable at all; and any society needs banks. The whole finance industry, which history suggests performs a necessary function, is a fragile tower of faith and trust (Don’t believe me? Check the headlines) and there have to be rules, and policemen there to enforce them, or you get, well, late 2008.
Greed · It doesn’t matter whether or not greed is good, because it’s just not going away. The surprising and counterintuitive thing about markets is that by aggregating the greed of individuals and institutions, on a level playing field with clear-cut rules, you get pretty decent outcomes with respect to asset allocation and meeting needs and avoiding waste. (I didn’t say optimal, I said pretty decent.)
The problem is that greed is after all greedy and thus motivates people to play as close to the edge of the rules as possible, and in a certain proportion of people, to break them cheerfully. This will never stop. Some speculators will always try to max out their leverage. Some bankers will always try to minimize their reserves. Some home-buyers will always try to get something bigger than they can afford. And so on and so on.
That means the regulations have to be written in such a way as to work even when people are trying to game them, and make it straightforwardly possible to detect and punish rule-breaking.
The Regulatory System Was Broken · I can’t imagine anyone disagreeing. They relied centrally on the notion of “credit rating” and that turned out to be a tissue of lies, in practice. They relied on balance sheets which while at the best of times arguably contain a certain amount of accounting sci-fi, in the finance business in recent years turned out to be to have almost no truth amid the fiction. And so on and so on.
What Now? · We don’t want to abandon free markets. We also don’t want to go through late-2008 very often. So we need better regulation. This doesn’t necessarily mean stricter regulation, just better. Obviously, the next US administration, and also the EU, and also the big Asian governments, are going to have to buckle down and conduct some agonizing reappraisals, and in principle be willing to blow up big parts of the regulatory system and start again.
I’m not an economics professional so my opinion on regulatory mechanics is not very interesting. But it seems crystal clear that government has absolutely no more important task, starting now.