Insanity and regulation
The proximate cause can be understood by describing two views of the economy. The first I shall call the Benthamite view. Jeremy Bentham designed a prison, which he called a panopticon, where the watchman observed inmates without them being able to tell whether or not they were being watched. In this model the economy is like a machine: when any of the economic actors do something wrong, the all-powerful watchman can step in and set the offending actor/prisoner right.
A more fruitful way of thinking about the economy, however, is from a Darwinian/Hayekian perspective. The economy is a complex adaptive system, which develops through a process of evolution, where the strongest, most resilient actors survive and grow, whilst the weaker agents fail. This process ensures system resilience through diversity and evolution. In this world view, the panopticon system of regulation is not only futile but actually increases the fragility of the system. The economic actors should not be put right but actually need to fail. If this does not occur, the system ossifies and becomes less resilient as the economic environment in which the financial system operates changes. A mono-culture ecosystem is the least resilient and this is what the regulatory system ensures. The role of government should be to support the evolutionary process, for example by ensuring that collateral damage from the failure of an agent is minimised, and that the participants do not engage in criminal activity, such as fixing interest rates.
So why has the Benthamite view prevailed? The main reason is probably that it suits the incumbent political and economic elites. Politicians of all persuasions like to be seen to be ‘doing something’; it doesn’t suit them to sit back and let evolution take place. The economic elites therefore have their position protected by the state, which effectively underwrites their liabilities, while regulation acts as a barrier to new entrants and hence competition.