The dilemma is whether to trust markets to be self-correcting, self-disciplined enterprises, or to regulate them to prevent excesses. Businesses calls, scream, to be free of the shackles of regulation, to be allowed to innovate, to make money and provide jobs, yet all too often fall, fail or implode due to their own excesses. Then, having failed, they plead with the government to rescue them.
Carmen Reinhart, a University of Maryland economist who has studied centuries of financial crises, concludes that blowups happen almost inevitably after financial markets are liberalized or some innovation allows capital to flow more freely.
"Market discipline exists in theory, but in practice, ahead of each crisis, what we see is quite the opposite," Ms. Reinhart says.
And it doesn't take a PhD or much research to know that.
Such discipline clearly broke down at places like Citigroup and Merrill Lynch, which in the past nine months have written down more than $80 billion combined on bad investments. They took too many risks on complex mortgage investments that they created but didn't adequately understand. More broadly, Wall Street's version of market discipline produced the worst housing crisis since the Great Depression – just a few years after a burst bubble in Internet stocks.
... written down more than $80 billion combined on bad investments. 80 billion is a lot of money. What's worse is that these were investments that they created but didn't adequately understand.
"What we have is obviously very dynamic markets that have the ability to run circles around regulators and they have an incentive to exploit every possible opening there is for regulatory arbitrage," says Raghuram Rajan, a University of Chicago economist who sounded alarms about the excesses building up in the financial system back in 2005.
Incentive to exploit? By being able to get away with it, by not being afraid of being caught. Yet they never consider that they might blow up, as Merrill and Citi and others have shown. Greed is allowed to rule.
The regulators are cracking down again now, two or three years too late.
True to form.