NEW YORK – In the last year, we endured a remarkable experience; after the bankruptcy of Lehman Brothers in September 2008, financial markets actually collapsed and required artificial life support. Nothing like this had happened since the Great Depression of the 1930’s.
What made this collapse so remarkable is that it was not caused by some external factor, but originated within the financial system itself and spread from there throughout the global economy. This was almost completely unexpected, as the prevailing view was that financial markets are self-correcting.
We now know that they are not. But, having gone too far in deregulating markets, we must resist a natural tendency to overcompensate. While markets are imperfect, regulators are not only human but bureaucratic and subject to political influence. Therefore, new regulations should be kept to a minimum.
Three principles should guide reform. First and foremost, financial authorities must accept responsibility for preventing asset bubbles from growing too big. Former United States Federal Reserve Chairman Alan Greenspan and others have argued that if markets can’t recognize bubbles, neither can regulators. Even so, financial authorities must accept the assignment: while they are bound to be wrong, feedback from the markets will tell them whether they have done too much or too little. They can then correct their mistakes.