Market punishment?

The AIG bonuses spectacle makes for great political opera, and it points to the importance of getting regulations right in the financial markets. For example, one simple lesson that comes from the AIG bailout (and several others, by the way) is the following: saying "And hey, don't be evil with that money" as a banker walks out the door with $30 billion to $150 billion of taxpayers' cash is probably not going to be an effective restraint on their activities. Doh!

I agree that it's fun to get your outrage on-it's such a great distraction from having to deal with the actual problems, which tend to be messy and intractable. But eventually we'll need to think about what really broke down in our financial system and how to solve the shortcomings we find. Once our anger cools a bit, we have an opportunity to go beyond knee-jerk reactions to symptomatic problems and dig into some essential issues that have been festering for quite a while. Will we be able to do that?

I really hope so, because one of these deep issues involves a fundamental misunderstanding of how financial markets work and how they need to be regulated. To highlight the misunderstanding, here's my view of how financial markets work. As in any market, financial service firms need to take risks in order to earn profits and grow. When a firm takes risks and proves to be successful, their actions are immediately copied, so that excess profits are squeezed out. This happens to financial services much faster than it does in the markets for other products (for reasons financial that I don't have time to get into), which puts even greater pressure on financial service providers to innovate and take bigger risks. In fact, the people who work in services are being paid to push the limits-the limits on what types of transactions can be done, how big the trades can be, how deals can be structured. Again, this is true of all business-but it plays out with more speed and fury in the financial markets.

If we look at the markets from this perspective, we should expect to see firms crash and burn when they try new things that don't work. We should expect to see occasional market strains, and even minor panics. And given the intense pressure on the players, combined with all the other market imperfections that are inherent to financial markets, we should expect to see players make bad decisions on a fairly regular basis.

Combine this with the fact that the market's ability to regulate itself is limited. The market possesses only two tools that it can use to reward and punish: changes in price, and changes in quantity. If you mess up, you can lose money, you can lose your company, you can lose your job. But that's it-and moreover, these outcomes aren't guaranteed, due to many market imperfections such as conflicts of interest. The market's rewards and punishments often aren't sufficient to keep the players from doing things that ultimately lead to disaster (or at least embarrassment).

Too many people, including key policymakers, didn't understand these limitations, so they let the markets go without sufficient supervision for a relatively long time. And we eventually wound up here. Now is the time to change our understanding of the markets, so that we can devise the right mix of government regulation and market discipline. We need to preserve the innovative force of the market and learn to rein it in, once we tire of playing Banker Whack-a-Mole.

Connel Fullenkamp is the associate director of undergraduate studies for economics. His column runs every other Tuesday.