The system works

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Markets end week on a positive noteWorld stocks tumble on credit worries

: an entity like Bear Stearns going down right now because high finance, principally via derivatives trading, is now constituted of several large players with interlocking trades and huge outstanding bets; Bear Stearns’ trading calls reportedly aggregated $10 trillion. This reinforces the “more regulation” question: shouldn’t more light shine on the fiendishly complicated instruments on the trading books of investment houses? So, yes, raise questions about moral hazard. Why rescue firms—Lehman Brothers and Merrill Lynch are reportedly vulnerable—that thought illiquid, long-term assets and short-term funding sources were forever compatible? Also, how many investment entities can be rescued? Should be rescued? But also recognise that capitalism will extract a high price for such help. After the dotcom bust, the separation of analysis and investment banking was enforced (that effort was led by Elliot Spitzer, who, as it turned out, didn’t pick up enough shady finance lessons, like avoiding one’s personal bank account for covert transactions). After the Enron scandal, the Sarbanes-Oxley Act on greater accounting disclosures came into force. For sure, some US legislators looking to seal re-election are pondering a post-subprime law now. Whether through lawmakers or regulators, investment houses will feel the heat, and they must. This is a certainty as the financial meltdown proceeds; a bet you can safely put your money on (if only you could find a punter in today’s market). The deeper the mess, the greater the extent of systemic reform, and interventions will be quick. This is a lesson Indian authorities must learn. Some Indian banks and companies are reportedly staring at derivatives-related losses. Regulator response must be quick but not ham-handed; don’t ban derivatives, force more disclosures and finetune the caveat emptor principle.

The late JK Galbraith had a formula that works remarkably well in describing every financial bubble: some new thing—subprimes, complicated derivatives—catches everyone’s fancy; a lot of people make money; some of them are held up as geniuses. After the big bust occurs, as Galbraith concluded, the system looks for scapegoats, who are usually yesterday’s geniuses. But capitalism also tries to and mostly finds its own solutions. That’s no guarantee against a future crisis, of course, because some other new thing will catch people’s fancy.