In my role as a financial bodhisattva (at least one level above guru) I would like to elaborate a bit on the quote Paul attributed to me. I am no enemy of government regulation. I believe that government has a critically important role to play in preventing financial crises and in protecting consumers of financial products. However, the problem is that financial regulation in practice is often not the kind I believe in. Regulators can and sometimes do become captives of the industry they are supposed to regulate. The result can be that the public interest suffers more under government regulation than in its absence.
Case in point: the regulation of 401k retirement plans. Under the Pension Protection Act of 2006, employers were given a mandate to automatically enroll employees in a company-sponsored 401k plan (although the employees can opt out.) The Dept of Labor was charged with setting rules for the default investments for auto-enrolled employees. Prior to the PPA, the default investment in most 401k plans was a stable value fund or similar investment that was guaranteed never to lose value. Under intense lobbying pressure from the investment industry the DOL ruled that stable value funds (offered primarily by insurance companies) would no longer be considered a qualified default option. Instead, only diversified investments containing a significant proportion in common stocks would be considered qualified. As a result of this new regulation many employer 401k plans have switched their default investment to "target date funds." On average these funds invest a high fraction in stocks -- even for a person at age 65 the average is 50%. In 2008 the average fund with a target date of 2010 lost 30% of its value. So instead of making 401k plans safer, the government has made them riskier for the most vulnerable group. Turning to swap contracts, I believe that for the most part swaps have been a welfare enhancing financial innovation since their first appearance in the 1980s. They have made it possible to achieve enormous benefits around the globe in rich and poor countries alike. But as often happens with technological advances in other areas such as building bridges,launching space shuttles, or transplanting human organs, failures occur -- sometimes spectacular failures. When failures occur, engineers, scientists and other experts are typically called upon to conduct detailed studies of what exactly caused the failure and how future failures can be prevented. This has not yet happened with swap contracts. I believe we will find that the failures in the credit default swap market were caused by inadequate central clearing mechanisms. How to best correct the problem is an open question in my mind. There surely is a potentially constructive role for government to play as overseer of the process, but the devil is in the details.

Why don't you call the financial business in modern America what it is? Corporate socialism!

TC

We must get rid of these bucket shop derivatives period. You cant regulate them, they must be eliminated. End of story. Without which the very integrity of the US dollar will being threatened and we will never be recession proof.

Zvi's comment speaks for itself.

"Corporate socialism" seems a bit over-the-top to me.

As to "bucket shop derivatives," the whole point of regulation is to move them out of the bucket shop and into the open air. Prohibiting them is like criminalizing the numbers game. What government did instead was reclaim it: as state lotteries. A second-best solution (and I personally disapprove of lotteries, for several reasons). But if people (or companies) want to bet, how do you stop them? Except making sure that they don't do by taking on debts they can't repay, and thus either forcing the knee-breakers or the taxpayers to fix the problem.

Nouriel Roubini, the NYU professor who predicted the current crisis, mentioned in a recent talk that throughout history, there's been a more or less regular cycle of economic bubble-and-bust every ten years, with only one exception during which we managed to prevent such crises from arising for a solid fifty years: the fifty years while Glass-Steagall and other post-depression securities regulation remained in effect. Then we allowed Republicans and "New" Dems to dismantle it, and we've got the biggest meltdown in human history.
I have no doubt we could at least slow Wall St. down if Congress were actually working for the people.

Human are prone to herd behaviour, it is embedded inside our DNA.

The purpose of financial regulation is to avert a systemtic collapse in the event of a massive loss of confidence. For example, bank deposit are guaranteed by the FDIC to prevent bank runs, and in exchange, the banks are required to keep a minimum capital ratio on loans outstanding. If you apply the same principle to derivatives, the Government will step in and guarantee the base recovery rates of a derivative contract. This may sound like a really bad policy, but it'll be much cheaper than the $700 billion TARP bailout.

The root of the problem is a mismatch between investors who are looking for 'A+' investment compared to what is available on the debt market. You can blame it on laws that restrict certain pension funds to invest only in 'A+' investments. Derivatives like CDOs are derived by merchant banks to converts 'BBB-' and lower rated debts into 'AAA' investments. It's the financial version of turning lead into gold. The financial alchemy is based on a mathematic model that is blessed by rating agency like Moody and Fitch. A flood of money suddnely become available, and a lot of it are poured into a housing bubble.

The current regulatory model has no easy tools for 'popping' a bubble. Raising interest rate is a very blunt instrument and slows economic activities overall. An effective mechanism would be an increase in taxation on profit for a sector: unfortunately it is also politically impossible. Many Central Banks are leaning toward tigtening lending criterias for loans during a bubble, and loosening them after a crash. The Fed will become the final arbitator, they will also control the terms on a CDS, the permitted composition of a CDO, and who can hold or buy/sell derivatives. (e.g. no insurance company can sell CDS like AIG).

The mantra of 'the market is always right' will soon be replaced by 'the Fed is always right'.