The Invisible Hand vs. The Big Stick

 “The reason that the invisible hand often seems invisible is that it is often not there.” (Making Globalization Work, 2006)

Nobel Prize winning economist (2001) Joseph E. Stiglitz

After finding out about it on MiradorWealth.com.au, I’m participating in an on line debate at Economist.com concerning regulating the financial system after this crisis.  It is interesting to read the comments because they come from all over the world and they come from folks that participate one way or another in the financial markets.  Right now 63% of the participants (led by American Economist Joseph Stiglitz) want more regulation of financial markets.

Here is his opening argument:

The current crisis is caused, in part, by inadequate regulation. Unless we have an adequate regulatory system—regulations and a regulatory structure that ensures their implementation—we are bound to have another crisis. This is not the first such crisis in the financial system that we have had in recent decades. Indeed, around the world, it is more unusual for a country not to have had a financial crisis than to have had one. They have occurred in societies with “good institutions”—like those in Scandinavia—and in societies without such institutions. They have occurred in developed and in developing countries. The only countries to have been spared so far are those with strong regulatory frameworks.

The side against regulation is taken up by Myron Scholes who is an equally impressive American Finance Professor.  Here is his opening argument:

There is now a rising chorus among regulators, politicians, and academics claiming the freedom to innovate in the financial domain should be curtailed.  This stemmed from the apparent recent failures in mortgage finance and credit default swaps and the apparent need for governments and central banks to “bail out” failing and failed financial institutions around the world directly through capital infusions and indirectly by providing a wide array of liquidity facilities and guarantees. They claim that freedom in global financial markets has proceeded at too rapid a pace without controls—in particular with an incentive system that rewards risk-taking at the expense of government entities—and as a result “throwing sand in the gears” of innovation will reduce “deadweight costs” and “moral hazard” issues.

Here are my thoughts.

Financial markets are not like other markets. To function properly, there needs to be transparency and trust. If transparency and trust are not there, they do not work, and if financial markets don’t work, nothing works in an economy.

Regulations should be put into place that increase transparency and increase trust. This does not mean they should be used to push social agendas like ‘affordable housing’. This means that rules of dealing in a market should be clearly established and a regulator should ensure they are followed. Rules concerning leverage, capitalization, prudent underwriting standards, and standardization of contracts all lead to transparency and trust. Countries with the standards attract capital and grow. Countries without do not attract capital and stall. Adequate regulation would have stopped this financial panic. We still have not unwound the rogue credit default swap market. We have yet to determine the full impact this will have on the current situation and it remains an unquantified risk hanging out there in the ethos like a cancer ready to spread. Unless we ensure these markets cannot be gamed, we will lurch from one financial panic to another.

As the financial crisis winds its way through history the discussion concerning the role of regulation, deregulation, and future policy will be an important one.  I suggest you get involved with that discussion because it is just that, an important one.