BRIEFING: "A short history of modern finance: Link by link; The crash has been blamed on cheap money, Asian savings and greedy bankers. For many people, deregulation is the prime suspect," The Economist, 18 October 2008.

A good rendition of the argument that says we're at the end of an extended period of deregulation that has logically run its course. First off, it notes that "the idea that the markets have ever been completely unregulated is a myth," pointing out the SEC example--something I see as being necessary on a Core-wide level. But the piece notes that, over the past three decades, "each step on the long deregulatory road seemed wise at the time and was usually the answer to some flaw in the system," like Nixon being smart enough to take us off the gold standard in 1971. Then Reagan and Thatcher effectively abolish controls on financial flows, now made possible by the floating currencies, allowing insurance companies and pension funds to move money across borders--fueling globalization. Then on to the so-called Big Bang of 1986 that allowed foreign brokerage firms into the market in Britain, following a step New York had made 11 years earlier. All those transactions reduced brokerage margins, forcing investment banks to cooperate more with commercial banks, who had the money, thus triggering the end to Glass-Steagall, the Depression-era law that had separated them. Commercial banks muscle into the underwriting of securities business, and investment banks responded by bulking up hugely. Then we see the rise of complex instruments, like options and swaps, leading to the rise of the quants which arbitraged price differences between markets, with currency swaps leading to interest swaps to . . . finally, credit-default swaps, all featuring small initial positions with huge exposure, so regulators fall behind in the shell game. Derivatives cause occasional but big hiccups across the 1990s, but Greenspan supported them (Age of Turbulence:

Being able to profit from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries which, in order to make an adequate rate of return on equity, have to heavily leverage their balance sheets by accepting deposit obligations and/or incurring debt. A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment.

True enough, it seems in retrospect, but a bit naïve given the lack of intermarket controls and transparency: high-trust, sophisticated markets selling their complex instruments to lower-trust, less sophisticated markets, and the shell game kicks into high gear in terms of uninformed risk-taking. Securitization, or the bundling of loans, "is another child of the 1970s," like so much of our modern, globalized world. It began in U.S. mortgage markets as part of our never-ending and very good pursuit of maximally widespread home-ownership--part and parcel of our economic system. But the system gets too cute for itself. Collateralized debt obligations (CDOs) bundle together the resulting bonds and then slice then horizontally according to the risk tolerance of the buyers. But the big danger is that commercial banks used securitization to access new sources of lending in markets, making our banks far bigger bettors on the market's health. The Basel accord was supposed to fix this by making banks hold more capital against such contingencies. All this good stuff led to many more homeowners in America, but that naturally drove up prices, and that unrealized wealth was then turned into additional debt (the second mortgages--an incredibly common sin to which I confess). But the train kept rolling with America's implicit Marshall Plan spend-to-fund-globalization strategy across the 1990s, aided by technological advances and India's and China's emergence. Then it all comes falling down, starting in spurts in 2007 but for real over the past few months. The verdict from the Economist:

Amid the crisis of 2008, it is easy to forget that liberalization had good consequences as well: by making it easier for households and businesses to get credit, deregulation contributed to economic growth. Deregulation may not have been the main cause of the rise in living standards over the past 30 years, but it helped more than it harmed. Will the new, regulated world be as benign?

Indeed.