I appreciate the opportunity to speak to this conference on financial innovation and financial crises. I plan to address the question: what is the role of government in reducing systemic risk in the financial markets?
The ongoing financial crisis has given a new urgency to this question. Government officials are now proposing legislation to expand significantly the role of government in the financial sector and beyond. The heads of the United States Treasury Department, the Federal Reserve Board, the Federal Deposit Insurance Corporation (FDIC), and the Securities and Exchange Commission (SEC) have all proposed the creation of a “systemic risk regulator,” which could be a new stand-alone agency, or part of the Fed, or a new council of existing regulators. Such an agency could have the broad power to review, regulate, and prohibit the use of financial innovations—both instruments and institutions—of the kind discussed at this conference. And it could be granted new resolution powers over private firms.
Proposals for the future role of government in the financial markets depend critically on lessons learned about the role of government in the current financial crisis. Broadly speaking there are two views.
One view is that “the markets did it.” The crisis was due to forces emanating from the market economy which the government did not control, either because it did not have the power to do so, or because it chose not to. This view sees systemic risk as a market failure that can and must be dealt with by government actions and interventions; it naturally leads to proposals for increased government powers. Indeed, this view of the crisis is held by those government officials who are making such proposals.
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