Guns, Drugs, and Financial Markets

CAMBRIDGE – The sub-prime mortgage crisis has demonstrated once again how hard it is to tame finance, an industry that is both the lifeline of modern economies and their gravest threat. While this is not news to emerging markets, which have experienced many financial crises in the last quarter-century, a half-century of financial stability lulled advanced economies into complacency.

That stability reflected a simple quid pro quo : regulation in exchange for freedom to operate. Governments brought commercial banks under prudential regulation in exchange for public provision of deposit insurance and lender-of-last-resort functions. Equity markets were subjected to disclosure and transparency requirements.

But financial deregulation in the 1980’s ushered us into uncharted territory. Deregulation promised to spawn financial innovations that would enhance access to credit, enable greater portfolio diversification, and allocate risk to those most able to bear it.  Supervision and regulation would stand in the way, liberalizers argued, and governments could not possibly keep up with the changes.

What a difference today’s crisis has made. We now realize even the most sophisticated market players were clueless about the new financial instruments that emerged, and no one now doubts that the financial industry needs an overhaul.