Credit crisis

Fixing finance

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.