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Paper overload

The intent behind new US regulation reflects emerging consensus

Written by The Indian Express | Published: March 28, 2009 10:35:48 pm

Some things we can touch or clearly understand,and are worth money we can estimate. Property,tangible and intellectual. When the millennium rolled around,the fraction of those within the modern financial system — as patent certificates,house deeds — was worth about $100 trillion. In addition to pieces of paper in the system which represented these things,other pieces of paper — share certificates,loan deposits — worth $170 trillion represented things almost as clearly understood: shares,simple debt,home loans. On that foundation,in a few short years,the financial system created a quadrillion dollars of value — at least in virtual terms. A quadrillion dollars is a sum large enough to be incomprehensible. It is certainly a few degrees of magnitude larger than the money that existed earlier. And much of that money was largely imaginary,and those trading it largely unregulated.

Of course,that is an oversimplification of sorts. The more efficient allocation of risk was indeed supposed to create value. And the true value of all that paper certainly can’t be aggregated through simple addition. Problematically,however,the re-allocation of risk represented by the expansion of paper may not have been actually optimal — it didn’t go to those most willing to hold it,but to those least able to understand it,to use Martin Wolf’s elegant formulation. Last year’s Nobel laureate in economics,Paul Krugman,has argued incisively recently that the whole risk-spreading model has,in his opinion,failed. Even given that may be an over-reaction,what is certainly true is that it is difficult to argue persuasively that the “shadow banking system” should stay beyond the reach of government scrutiny.

The US’s new regulatory proposals are best seen as a first attempt to reflect this emerging consensus. Included in Treasury Secretary Geithner’s proposals are: an attempt to unify regulation; to bring hedge funds and private equity into the regulatory net; to more closely examine financial derivatives; and to take control of troubled institutions that jeopardise the entire sector. The US Congress seems to back Geithner’s demand for “new rules of the game”. Sensible economics might too.

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