Megan McArdle writes,

our regulatory model still works on the assumption that the technocrats can figure out what is safe, and then let the public buy it, and nothing will ever go wrong. Oh, maybe it’s not working that way right now . . . but that’s because the other party is in charge. Or the regulators got corrupted. Or the Moon was in Taurus while Saturn was in Capricorn, a constellation that will not recur for another seven thousand years.

On financial markets, I am in the middle between the Progressive view that government can guarantee everything and the libertarian view that the government should guarantee nothing.

My view is that financial markets are inherently unstable, because financial intermediation inherently replaces transparency with trust. If my bank were perfectly transparent, then I would know everything about its loans, including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money. But in that case, I would not need a bank–I could just make those loans myself. So if you assume perfect transparency, you assume away the need for financial intermediation.

In fact, you have to assume the opposite of perfect transparency. You have to assume highly imperfect transparency, with reputation and trust serving as substitutes.

In banking, deposit insurance helps facilitate trust. A private insurance pool might work, but people trust government-provided deposit insurance even more.

With deposit insurance, the consumer loses all motivation for worrying about the bank’s risk management. By the same token, the insurer has to worry a lot. In the U.S., the FDIC has been getting better over the years, but you can never get complacent. Any system can be gamed eventually, so it’s a challenge for the regulators to stay one step ahead of the banks.

What we see with Bear Stearns, Freddie and Fannie, Lehman, and AIG insurance are institutions that are not FDIC-insured banks where nonetheless a question arises about whether some of their creditors ought to be protected by the government. I think that just about everyone is unhappy that these decisions are being made ad hoc, after the firms got in trouble, rather than having rules set ahead of time. But maybe what the government is doing is actually pretty reasonable. You can think of the Fed and Treasury as trying to buy good assets at cheap prices, at a time when private intermediaries have lost the trust of investors, which puts undervalued assets out there to buy. But you want the government to get out of the hedge fund business sooner, rather than later. It’s not a safe business.

Another point to toss into the mix is that the blow-up has not come from private hedge funds. If you think that leverage and lack of regulation are the big risk factors, those are the guys that you would expect to be experiencing all the problems.

Overall, I think that having some regulated, insured institutions, like the banks, is good. I don’t think we can or should try to regulate everyone. Regulators should try to anticipate crises and prevent them. But almost by definition, the crises that do occur will be ones that they did not anticipate, and the responses will have to be somewhat ad hoc.