Viva la Regulacion?

Many of my musings over the last several months (again sorry for that brief hiatus) concerns attempts to legislate our way out of the Credit Crisis. Since I rarely attempt to match wits with someone that has an British accent, I defer to an article in this week's Economist, which succinctly argues the success of the current financial system and the danger of the alternatives.

Here are few of the highlights:

As this week's special report on international banking makes clear, the main structural causes of trouble—the collective misjudgment of risk; a zealous search for yield; and the failure of oversight—are deep-seated. In financial history they crop up time after time. Financiers are rightly rewarded for taking risks, which by their nature cannot be entirely managed away or anticipated. The tendency for success to breed complacency and recklessness is as ingrained in financial markets as it is in any other walk of life. However bankers are paid, they cannot just sit out a credit boom; they have to keep dancing. Regulators lack the knowledge, the clout (and often the talent) to keep up with the banks' next brilliant scheme.

That reads like an indictment, until you consider the alternatives. Western finance, to paraphrase Churchill, is the worst way to allocate capital, except for all those other forms. It is obviously better than the waste and dysfunction in China, where centrally planned capital is dished out to the well-connected. But it is also better than the financial system the West used to have. Thanks to the astonishing innovation of the past few decades, derivatives can help firms and investors to hedge risks (there are plenty of Chinese manufacturers who would be grateful for an easy way to soften the impact of exchange-rate shifts). Securitisation widens access to capital for borrowers and to assets for investors: it can finance everything from water utilities to film studios. Leverage brings more lazy companies within reach of determined investors and more homes within reach of poorer consumers.

It is true that financiers have enjoyed vast profits—and the vast salaries that go along with them (pay at American investment banks has been nearly ten times the national average). But the collapse of the credit bubble will bring that down. And despite all the disasters, there are signs of finance's resilience. In the past few months the banks have commanded enough confidence to raise $200 billion in new capital from investors. Bear Stearns and Northern Rock were calamities, but rare ones, because the vast overall losses were spread far and wide. This time, there has been no industry-wide government recapitalisation. After 20 years of growth, the flaws of modern finance are painfully clear. Do not forget its strengths.