THE FREE MARKET FAIRY IS 0-FOR-3

Nouriel Roubini points out that 3 MAJOR pillars of the temple of the Free Market have been toppled by the financial meltdown.

Laissez-Faire Capitalism Has Failed
Nouriel Roubini, 02.19.09, 12:01 AM EST
The financial crisis lays bare the weakness of the Anglo-Saxon model.

There is the failure of ideas--such as the "efficient market hypothesis," which deluded its believers about the absence of market failures such as asset bubbles; the "rational expectations" paradigm that clashes with the insights of behavioral economics and finance; and the "self-regulation of markets and institutions" that clashes with the classical agency problems in corporate governance...

Uncle Alan used to firmly believe the last pillar but no longer. At the end of his piece, Roubini brings up a VERY important point: How do we design a system is which it pays to follow the rules?

But the design of the new system should be robust enough to counter three types of problems with rules. A tendency toward "regulatory arbitrage" should be kept in mind, as bankers can find creative ways to bypass rules faster than regulators can improve them. Then there is "jurisdictional arbitrage," as financial activity may move to more lax jurisdictions. And, finally, "regulatory capture," as regulators and supervisors are often captured--via revolving doors and other mechanisms--by the financial industry. So the new rules will have to be incentive-compatible, i.e., robust enough to overcome these regulatory failures.