We know that the market system’s strength is not to avoid mistakes, but to sanction and correct mistakes. Its philosophical foundation is not the Uto...

We know that the market system’s strength is not to avoid mistakes, but to sanction and correct mistakes. Its philosophical foundation is not the Utopia of a flawless economy, but the acceptance of human fallibility. And we know that prices are the essential vehicle of adjustments.

Volatility, the name we give to the restless movement of prices, manifests itself in hourly, daily, quarterly, up to multiyear movements. They are all ‘corrections’, triggered by new information or revisions of judgements over previously available information. Most corrections are totally harmless; some may be painful or even fatal for individual firms or households, but harmless for the system; yet others hurt entire branches or even the whole of the economy, although they do not permanently impair the system. The word ‘crisis’ is appropriate when the correction is particularly sharp and the return to track particularly laborious. Accepting the market economy implies coming to terms with the inevitability not only of corrections, but also of crises.

Where should the present crisis be placed in this scale? Of which system is this the crisis? Not – as some pretend – of capitalism or of the market economy, in the same way as the fall of the Berlin Wall marks the final crumbling of central planning. The system of which this is the crisis, is the particular variety of the market economy that we have seen at work in the last three or four decades.

How will the crisis be surmounted? There are here, to be sure, two issues in this single interrogation: first, how to steer the economy out of the mess and, second, how to reshape the economic and financial system in order to avoid repeating it. This is the common distinction between management and prevention.

Before concentrating on the foundations of prevention, its interaction with management should be clarified. First, the crisis itself, including the public action undertaken to manage it, shapes a new reality, and it is with this reality, not with the pre-crisis configuration, that politics will be confronted. Indeed, the crisis is a ‘reformer’. One example is the come back of universal banking, with the transformation of Goldman Sachs, Morgan Stanley and American Express into Bank Holding Companies; another is the consolidation of financial institutions produced by the fall of Lehman and the takeovers of Bear Sterns and Merryll Linch.

Second, prevention starts before crisis management ends: the conferences of Havana, Bretton Woods, San Francisco, were held while World War Two was still raging. Many of the actions undertaken by public authorities to manage the crisis are chosen with the ‘after crisis’ in mind, just as the strategy of the allied powers combating in Europe aimed not only at winning the war, but also at influencing the post-war borders.

Third, the legacy of the crisis should not be untouchable for the architects of the reconstruction. Certain public interventions required and justified in the emergency, should not create a precedent for ordinary times and should be quickly reversed after the storm. Injections of public capital into private institutions or the acceptance of dubious collateral by the central bank are examples in point; a main aim of reforms is precisely to avoid the repetition of unorthodox measures that proved indispensable in the emergency. This holds also for structural changes produced by the storm: if, for instance, part of the problem was that too many financial institutions were deemed too big to fail and the crisis has produced further consolidation, there could be good reason to pursue deconsolidation as part of the recovery programme.

The reform agenda is long. It comprises the role and structure of regulators and a redrawing of the list of regulated institutions, access to central bank facilities and accounting standards, compensation policies for directors and managers and pro-cyclicality of regulatory requirements, rating agencies and the financial infrastructure. Rather than reviewing the technical issues involved in this agenda, I will try to identify a few aims which should guide the entire reform. Such aims are formulated in a conceptualized form, which may appear removed from the frontline of the present debate. Conceptualizing, however, is not escaping from reality but, on the contrary, going to the heart of it.

Reform, however, should stem from an in-depth understanding of the fundamental flaws, which have developed in the last three decades, and from recognition that it is the task of public policies, not of the market itself, to remove, as much as possible, these flaws. There is of course no certainty that the correction will come, but there can be little doubt that to make it come is a task of politics, not a spontaneously generated order à la Hayek.

One of the flaws that are at the origin of this crisis is market fundamentalism. This amounts to saying that what should be blamed is politics, not the market. Indeed, it was known that the proper functioning of the market economy rests on an appropriate mix of private and public actions and that the animal spirits produce collective prosperity only if they operate within the framework of legislation, regulation and supervision. It was also known how, by and large, this framework should be constructed and operated. The fact that in the last three decades the public side of the economic system omitted to make this framework evolve at the same pace at which the private side was moving and even dismantled relevant parts of it can only be called a politics failure. Politics failures are usually seen as due to an excess of government intervention; here they were due to a lack of government.

Market fundamentalism is the appropriate label for the radical wing of a vast movement of ideas, which has dominated economic thinking and policymaking in the last thirty years. Such movement entered the scene as a reaction to excessive political activism and mistrust of markets of a previous period. In the course of five decades – through the mistaken response to 1929 and the experience of the New Deal – the notion that government intervention is a necessary component of the market economy had turned from provocation to orthodoxy to overzealous implementation. In the 1950s its acceptance was still cautious, but by the mid 1960s it had become prevalent and often simplistically overstretched. By the end of the 1970s, against a background of high inflation and government deficits, the time came for the pendulum to reverse its movement: the swing began in Chile with the Chicago economists hired by Pinochet, and continued with the accession to power of Margaret Thatcher (1979) and Ronald Reagan (1980).

Jeremy Bentham's presumption that government ‘interference is, at the same time, generally needless and generally pernicious’, against which J.M. Keynes, as far back as in 1926, had invoked The End of Laissez-Faire, was restored. ‘Be quiet!’ had been Bentham’s admonishment to governments. ‘The market knows best’ was the battle-cry of the growing phalanx of new volunteers fighting – in universities, trading rooms, newspapers columns, think tanks, central bank and Treasury departments, parliamentary committees – for less government, less rules, more Darwinian selection (in science, though, some of these volunteers were creationists).

Market fundamentalism took a number of forms. One was the abdication of policy makers (politicians and officials alike) from their institutional role. Deregulation became the top, sometimes almost exclusive, item of the economic policy agenda. ‘Less is more’ was stated by an eminent member of the EU Commission. Policy makers became not only non-interventionist and active deregulators; they even professed agnosticism on key economic concepts as equilibrium exchange rate, neutral level of the interest rate, core inflation, full employment, etc. The difficulty of measuring such concepts was taken as an argument to exclude them from the kit of analytical policy tools. The only ’real thing’ was the view of the market; any attempt to form the view of policy was an illegitimate interference and circumstantial evidence of heresy.

The three decades in which market fundamentalism replaced excessive activism as radical version of the dominant policy paradigm are those in which public agencies (central banks, financial regulators, etc.) fought and won their battle to become independent of political bodies. They fought it not only in the name of the technical nature of their task, but also as part of the revival of market principles. What has perhaps not been sufficiently perceived was that emancipation from politics risked to give way to the blandishment of business interests, particularly in a time in which the intellectual and social prestige of the private sector obscured the pride to serve the public interest. And not many officials were familiar with the economic literature dealing with the risk of capture of the regulator.

The idea that markets, in general, and financial markets in particular, are capable of regulating themselves and therefore do not need public regulation is the most patent policy failure and is a direct manifestation of the fundamentalist attitude. In the last two decades the agenda of public policy concerning the financial sector has mainly consisted in removing regulatory barriers, resisting proposals to regulate new players, blurring the frontier between licensed and non licensed institutions, getting close to a return to free banking.

Unfortunately, one excess paves the way to its opposite. The exaggerated retreat of public policy from the task of prevention has contributed to produce such a systemic collapse that, when the time of management came, all the taboos of market fundamentalism crumbled and public measures out-passed even the inclinations of more balanced policy makers.

Now that it has swung, those who – like the author of this article – like the pendulum in a median position between economic anarchy and government intrusiveness, should get ready to fight again in defence of market principles.