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 1980s 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.

But what, exactly, needs to be done?

Economists who focus on such issues tend to fall into three groups.
 

First are the libertarians, for whom anything that comes between two consenting adults is akin to a crime. If you are selling a piece of paper that I want to buy, it is my responsibility to know what I am buying and be aware of any possible adverse consequences. If my purchase harms me, I have nobody to blame but myself. I cannot plead for a government bail out.
 

Non-libertarians recognize the fatal flaw in this argument: financial blow-ups entail what economists call a “systemic risk” - everyone pays a price. As the rescue of Bear Stearns shows, the government may need to bail out private institutions to prevent a panic that would lead to worse consequences elsewhere. Thus, many financial institutions, especially the largest, operate with an implicit government guarantee. This justifies government regulation of lending and investment practices.

For this reason, economists in both the second and third groups - call them finance enthusiasts and finance skeptics - are more interventionist. But the extent of intervention they condone differs, reflecting their different views concerning how dysfunctional the prevailing approach to supervision and prudential regulation is.

Finance enthusiasts tend to view every crisis as a learning opportunity. While prudential regulation and supervision can never be perfect, extending such oversight to hedge funds and other unregulated institutions can still moderate the downsides. If things get too complicated for regulators, the job can always be turned over to the private sector, by relying on rating agencies and financial firms’ own risk models. The gains from financial innovation are too large for more heavy-handed intervention.
 

Finance skeptics disagree. They are less convinced that recent financial innovation has created large gains (except for the finance industry itself), and they doubt that prudential regulation can ever be sufficiently effective. True prudence requires that regulators avail themselves of a broader set of policy instruments, including quantitative ceilings, transaction taxes, restrictions on securitization, prohibitions, or other direct inhibitions on financial transactions - all of which are anathema to most financial market participants.

To grasp the rationale for a more broad-based approach to financial regulation, consider three other regulated industries: drugs, tobacco, and firearms. In each, we attempt to balance personal benefits and individuals’ freedom to do as they please against the risks generated for society and themselves.

One strategy is to target the behavior that causes the problems and to rely on self-policing. In essence, this is the approach advocated by finance enthusiasts: set the behavioral parameters and let financial intermediaries operate freely otherwise.

But our regulations go considerably further in all three areas. We restrict access to most drugs, impose heavy taxes and marketing constraints on tobacco, and control gun circulation and ownership. There is a simple prudential principle at work here: because our ability to monitor and regulate behavior is necessarily imperfect, we need to rely on a broader set of interventions.

In effect, finance enthusiasts are like America’s gun advocates who argue that “guns don’t kill people; people kill people.” The implication is clear: punish only people who use guns to commit crimes, but do not penalize others as well by restricting their access to guns. But, because we cannot be certain that the threat of punishment deters all crime, or that all criminals are caught, our ability to induce gun owners to behave responsibly is limited.

As a result, most advanced societies impose direct controls on gun ownership. Likewise, finance skeptics believe that our ability to prevent excessive risk-taking in financial markets is equally limited.

Whether one agrees with the enthusiasts or the skeptics depends on one’s views about the net benefits of financial innovation. Returning to the example of drugs, the question is whether one believes that financial innovation is like aspirin, which generates huge benefits at low risk, or methamphetamine, which stimulates euphoria, followed by a dangerous crash.