After three decades of rolling back the State and leaving a greater role for markets, the freezing of global credit markets and the frenzy in global energy and food markets is causing politicians the world over to question whether the trend has gone too far. It may be the turn of markets to have their wings clipped. Should we welcome or fear this? We should fear this.

The fundamental reason for commodity prices to rise so sharply is the demand shock of China and Indian growth (these two countries alone account for 70% of the growth of demand for oil over the past six years), supply uncertainties related in part to geo-politics, (thanks Presidents Bush and Putin), and a set of other factors which limit the sensitivity of demand and supply to price changes. These include government subsidies to producers and consumers which are particularly prevalent in India and China.

Financial speculation has played a minor role in the energy price jump. Without speculation, commodity prices would still be sharply higher. Moreover, that part of the price increase that relates to speculation, may not be unfounded froth, but the bringing forward of price rises that the markets estimate will be required to clear markets in the future. Markets do not wait for the future; they anticipate it. Where speculation represents market estimation of future supply and demand factors, the appropriate policy response is to ensure that the price signal gets through to producers and consumers while at the same time helping the most vulnerable in society through income transfers.

A case may be made for government manipulation of prices on two narrow grounds. The first is if speculation is part of an attempt to ?corner? the market. This is against the ?rules? and while commodity markets are not regulated directly, speculators need banking counter-parties to finance and settle trades and the banks are regulated so regulation against market distortions could come through the back door. However, it has not been convincingly argued that current price rises are due to cornering. The second grounds for government intervention is if speculation is feeding upon itself, creating a bubble that the inflation and subsequent deflation of which will cause economic dislocation. This is a worry. There are similarities between where we are with food and energy prices today and where we were with credit risk before.

Bubbles are found at the intersection of two things, a belief system which argues that something is or has become a sure bet (earlier sure bets included railroads, sovereign credits, Asian equities, the internet, and houses) and the ready availability of credit.

There are a number of reasons why the international financial system may be more prone to bubbles today, though history is encumbered with them too. The principal reason is an asymmetry between potential rewards and risks. If in the past financial sector participants needed twenty years of good bank bonuses before they could retire, and within those twenty years there would be 2-3 economic cycles, they were incentivised to consider long-term results and reputation issues. If it now takes just three years of good off-shore bonuses before bankers can retire and within those three years there may be just one trend, the incentives to gamble for short-term riches have markedly increased. While speculation serves an important and valuable role in the economy; we are currently over-investing in it.

But this will not be rectified through greater sanity, disclosure, regulation or tax take on the part of market participants. It may be addressed through more appropriate regulation of the amount of capital the banks set aside against their lending. Although hedge funds and institutional investors are key players in financial and commodity markets today, the fuel for any speculative frenzy is the credit supplied by the banks. Current global banking rules fuel asset market bubbles by facilitating an expansion of credit during booms. Perversely, markets failed because of regulatory failure.

As Professor Charles Goodhart and I have shown (Financial Times: January 30 and June 4, 2008), a number of simple instruments can be used to turn the existing rules into contra-cyclical measures that will act as a brake against speculation carried out by banks and others who use the credit of banks to speculate. There is already scope within the existing rules for national supervisors to adopt contra-cyclical measures, like capital charges or provisions that rise and fall with the economic cycle, but it is our feeling that supervisory discretion often falls victim to political pressure and regulatory arbitrage. Contra-cyclical rules are best agreed upon internationally. Rather than tinkering around with markets, the moment is ripe for policy makers to make a strike for a greater stability orientation to financial policy through reform to local and international banking rules.

Avinash D. Persaud is chairman of Intelligence Capital Limited, a financial advisory firm and emeritus professor of Gresham College