Creating financial harmony: what role for government versus the market?

• Author: Beddoes, Zanny Minton
• Position: Essay

The Cato Institute has coined a fresh phrase--"financial harmony"--to describe the challenge we face in the aftermath of the biggest financial mess since the Great Depression. But what is financial harmony? Does it prize innovation or stability, the absence of crises or the efficient intermediation of credit?

It is tempting to answer "all of the above." And given where we are today, there probably is room for improvement on all fronts. But there are also real tradeoffs involved in financial reform--and where you stand on those tradeoffs determines the appropriate role of government versus the markets (see Beddoes 2008). Dramatically raising capital requirements, for instance, may reduce the odds of crises, but likely at the expense of costlier borrowing.

Those who believe that modern finance has brought plenty of crises with few real economic benefits are keener to turn the clock back to an era of stodgy banks and plain vanilla products. (1) Those who believe deregulation and inadequate supervision were the primary causes of the financial mess focus on the need for more stringent rules and closer oversight. If, by contrast, you put greater weight on policy errors, from loose monetary conditions to the subsidization of leverage, you see less to be gained, and more to be lost, from a reform effort focused too heavily on regulation. Such skeptics also tend to be more worried about the unintended consequences of government intervention.

Path to Financial Harmony

The right route to financial harmony also depends on where you start from. And we begin from a position where the balance between government and markets has dramatically shifted. Finance has long been subject to greater government involvement than other areas of the economy. With good reason. Finance is special, both in its predisposition to booms, its vulnerability to panics, and its ability to wreak havoc on the rest of the economy. From Walter Bagehot onwards that fragility has, rightly, been seen to justify both regulation and intervention in times of crisis. We have central banks to act as lenders of last resort; we have deposit insurance; we have learned over successive crises in the past decades that systemic bank collapses invariably demand an infusion of public capital.

But over the past year we have taken a great leap toward government--with fiscal and monetary intervention that is mind-boggling in its size and scope. Given the scale of the collapse, and the risks of repeating...