IN every walk of life there are people who are greedy, selfish and sometimes those who downright cheat. Some MPs stretched their expenses to the limit, some people have cheated on social security benefits and some bankers have behaved in a totally irresponsible way.
Greed is never a virtue but, in a market economy, the effect of greed is normally attenuated. It is difficult for me to get rich in business unless I provide something of value to somebody else. Occasionally, the selfish, the greedy and the incompetent prosper at the expense of others, but it is not the norm.
If greedy, incompetent and selfish bankers have managed to bring down the financial system, then there must be something from outside the system that has made it malfunction. Politicians, regulators and central bankers are responsible for creating what liberal economists call "the rules of the game" within which markets operate and they have designed them badly.
As such, the argument of the Institute of Economic Affairs' new publication
Verdict on the Crash  is that Government failure and not market failure is responsible for the collapse in financial markets.
It is now widely accepted that the boom and bust which culminated in the Great Depression of the 1930s stemmed from a catastrophically mismanaged monetary policy. So, it is natural that we should start by examining monetary policy to see if it was a cause of the crash of 2008. And so it turns out to be.
Low interest rates led to monetary aggregates expanding, an asset-price boom, low saving and a boom in consumption. Higher asset prices raised the value of collateral against secured loans thus encouraging more lending and higher leverage while reducing the apparent risk faced by lenders and borrowers.
Low interest rates encouraged unsustainable borrowing, consumption and investment and exacerbated the problem of global imbalances. For six years from 2001, the US Federal Reserve sent the message to participants in financial markets that, if the markets were to fail, the Fed would underpin them.
No wonder any consideration of risk went out the window. Policy in the UK was also irresponsible, though over a shorter time. The man who is now our Prime Minister told everybody that he had abolished boom and bust. Is it any wonder that people under-priced risk?
But, notwithstanding all this, why were the complex securitisation instruments that brought down the banks created and traded in such magnitude and why did they become poisonous?
My high school economics teacher used to quote an old banking adage: "A message to bankers who should heed it, don't lend money to those who need it." Banks don't willingly lend to people who have no ability to repay. But, in America, the Community Reinvestment Act backed up by progressively tightening state regulation more or less forced banks to lend to bad risks. By 2005, the US mortgage giants had explicit targets to provide more than 50 per cent of their financing to people on below median incomes.
In other ways, government policy and capital regulation had a big part to play. Fannie Mae and Freddie Mac drove and developed the market in securitised mortgages. They were the creation of politicians and underwritten by government. The providers of capital knew that there was an implicit government guarantee if things went wrong.
Of course, nobody forced British banks to buy these instruments. But international banking regulations led to two tragic consequences. They distorted the activities of banks, encouraging them to take on gearing in more and more complex ways and to give the impression that they had offloaded risk through securitisation. Secondly, they strongly encouraged the adoption of similar types of risk models throughout the banking system. Regulation has treated the system in such a uniform way that, if problems arose in one bank, the failure of the whole system was virtually guaranteed. It is simply a conceit that more and more regulations can bring our banking system to perfection.
Readers should take a look through the FSA handbook. The full handbook contains 10 sections. The section entitled "Prudential Standards" is divided into 11 sub-sections. The sub-section "Prudential Sourcebook for Banks, Building Societies and Investment Firms" is made up of 14 sub-sub-sections. The sub-sub section "Market Risk" is divided into 11 sub-sub-sub sections. The sub-sub-sub-section on "Interest Rate PRR" has 66 paragraphs. This is what socialists call "principles-based, light-touch regulation". As far as I could see, based on this example, there could be more than 1,100,000 paragraphs. Remarkably, I could find nothing on liquidity risk, the main failing of Northern Rock. What a tragedy this whole charade is.
The evolution of regulation over the last 20 years has encouraged the markets to pass responsibility to the regulator. The most important relationships are now between banks and their regulators. Sadly, shareholders gave up monitoring. They were encouraged to think it was not necessary.