As a Twitter user, this burningpants correspondent has been confounded by the flurry of tweets by senior economic analysts clamoring for more regulation and government intervention into the markets. Marx has come back into vogue for many… again.

The media is having a field day with the theatre of doom and gloom. The doom theatre has its own bad guys such the speculators, the hedge funds, the short sellers, the greedy bankers. According to Matt Damon narration in the flick Inside Job, these individuals are often fuelled by cocaine snorting prostitute junkies too!

The baddies even have their own ideology: the efficient market hypothesis where the assumption of rationality holds sway. However, according to politicians and numerous academics, rationality does not rule in financial markets. Rather the animal spirits, as Keynes would label, rule and control asset prices in markets.

The concept is seductive especially in the context of the past month. Understandably, most people are questioning the utility of free markets, especially if they see their wealth being diminished.

When confronted by these seemingly excessively volatile markets, more regulation seems to be the first port of call rather than tackling the rot that causes many of these crises.

However, just how effective are regulations? It is the constant meddling in asset markets, which seem to throw up unintended and often disastrous consequences, that is the problem. The problem seems to be a failure to grasp basic principles behind the efficiency of a capitalist economy.

Meddling by regulators in markets often leads to uncertainty and false pricing signals being established, where the risks are often misconstrued – and often lead to even more disastrous outcomes than could have been foreseen by the regulator.

Examples abound. We have the Basel capital regulations. Basel III (though the BIS would probably prefer to think of it as Basel 2.1) will be phased in over the coming years and will place ever tighter capital controls on deposit institutions.

Although Australian banks are in a good position to cope with the changes, further afield there is already concern that these regulations will just cause further uncertainty, decrease profitability and prompt job cuts at many global banks.

When many countries in Europe seem to be struggling to get their economies back on track, enforcing a greater regulation that could force strangle lending activity doesn’t seem like a great idea.

If a bank is being poorly run or has exposed itself to excessive risk, let the market push its price down and increase its cost of capital – which is what occurred in Europe recently. Or just let it fail.

Even with capital regulations we still saw many bank failures in the US, where, for example, the regulations are actually tighter than what the Basel accords stipulate.

And despite its best intentions, further regulation will not stop the rot.

For example, under the Basel, I accord, a bank was required to hold 8% capital against default risk – to get around the regulations banks would just securitise the loan and keep it off balance.

Regulations just seem to add ever-increasing complexity and distortion to the financial world.

Most recently we saw a ban in Europe on what many would consider the most nefarious of capitalism’s activities – the act of short selling (of bank stocks in this instance). Again, regulators seek to step in and control aspects of the market, and this time at the fundamental level of pricing.

Has it worked? Probably not. On Bloomberg a scholar studying the impact of short selling bans in 30 countries is quoted:

“In contrast to the regulators’ hopes, the overall evidence indicates that short selling bans at best left stock prices unaffected and at worst may have contributed to their decline.”

At most, governments only seem able to hinder or delay the process. So what is the alternative? Nothing – let the markets do their job.

In a world of only long positions, the discipline of the markets would be significantly diminished.

We tend to forget that the poor practices and performance of business, and governments, are often exposed by short sellers and speculators.

With so many players in the markets, there is no other economic system that can allocate capital as efficiently as capitalism. Meddling in the pricing mechanism shrouds the risk underlying investments.

Why do regulators believe that they have the capacity to determine what is the fundamental value of a security when even the empirical evidence suggests otherwise?

In these turbulent times, it is perhaps best to be guided by the genius of Hayek. That is, no academic, bureaucrat or regulator can ever fully explain market price movements and therefore control them.



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