The Atlantic's Business Channel has been buzzing with a debate on whether unregulated shadow banking caused the financial crisis. It all began by a Washington Post blog piece by a University of Oregon economics professor named Mark Thoma. I agree with very little of what he wrote. Instead of dissecting his entire post, I'd like to focus broadly on the chorus that continues to grow in volume lamenting that greater regulation could have prevented the crisis.

Technically that chorus is correct. Regulation can eliminate all financial risk if it's strict enough. If banks, for example, had 100% reserve requirements, no one would ever have to worry about their deposits being at risk (putting bank robberies or natural disasters aside), because the bank would always be able to back up 100% of deposits. Of course, that safety comes at the cost of the bank never being able to make any loans.

By allowing lower reserve requirements, banks can have a capital base that, under virtually any circumstances outside a bank run, is adequate to provide their deposit base with sufficient liquidity. The reserves a bank is not required to keep can be loaned out to businesses or individuals so the bank can earn interest and provide its depositors with some interest of their own. After all, it's the interest that provides most of the incentive to have your money in the bank in the first place. Otherwise, you might as well keep it in a fireproof safe in your home. That means that if 100% reserve requirements were demanded, banks would probably cease to exist, and so would most credit.

An important point follows: in order to allow for growth and innovation, regulation must be kept in check. If you over-regulate, you stifle the market. Of course, it's not over-regulation that many in Washington are worried about -- the common complaint today is about under-regulation. Free market advocates claim that the less a market is regulated, the more it can flourish. The past two years haven't strengthened their argument.

I think the free market argument works very well in theory. Less constraint means more opportunity for innovation and creativity. The argument that freedom allows for innovation is too obviously true to be ignored. History shows how much more creativity and progress came out of societies with greater liberty. Economic freedom is similar to any other type of freedom, like artistic freedom for example; it just involves dollars and contracts instead of paintbrushes and canvases. The difference, of course, is that there's more at stake in economics: money makes the world go around, and paint does not.

Free market theory assumes rational people with good information. In the real world, however, three important factors must also be considered: evil, negligence and stupidity. Those three factors are likely the causes for our current financial meltdown, though I would argue it's more the latter two than the first. I think investors, rating agencies and even investment bankers are not particularly evil people. They're just probably not as smart or prudent as they think.

Given the magnitude of the crisis, it seems hard to argue against the claim that some regulation should be imposed to moderate that evil, negligence and stupidity. But how much regulation does it take? I guess it depends how evil, negligent and stupid the people are running the show. Considering the toxic mess they've made of things, well, draw your conclusions as you may. I just think it's important not to lose sight of the fact that there's a trade-off, since regulation can stunt innovation and growth.

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