"The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

Arnold Kling has an excellent post on EconLog:

"One topic that came up was the principal-agent problem of financial firms. It was argued that managers took advantage of shareholders by taking undue compensation and excessive risks. I was one of those who believes that managers duped themselves and that they regret how this worked out for them personally. However, had the incentives been radically different (for example, if one could be sent to prison for improper risk-taking at a financial firm), I can imagine that fewer managers would have duped themselves.

My sense is that there is a widespread public perception that financial managers deserve to be punished more than they have been, regardless of whether such punishment is necessary or sufficient to deter excessive risk-taking. I think that if we are going to have government guarantees, then punishment as a deterrent is worth considering. For example, I would like to see those responsible for under-funding defined-benefit pension plans go to prison. Of course, we will not see that happen, since it would mean that every legislator would be behind bars.

Anyway, apply the principal-agent paradigm to government. Think of "we the people" as the principals and government officials as our agents. To me, the principal-agent problem involved with government is much worse, both in theory and in practice, than that involved with financial firms."

I basically agree with this. I find that manager's pay is too high, but I'm more worried about actual fraud, negligence, and fiduciary incompetence. I would rather the shareholders and clients take a more active interest in their investments, and I worry that these rules might lead to more slumbering on their part. However, I can see the point, and I don't believe that they deserve these high salaries, so I'm not going to put up much of a fight. I would simply have wished the clients and shareholders had done this. I actually do believe that there was a lot more misconduct than he seems to.

"Another issue is transparency. In the used car market, if the government knew the true quality of every used car, then I presume it should disclose this information to get rid of the "lemons problem." Next, apply that to banks. If the government knew the true condition of every bank, and disclosed which ones were in trouble....there would be runs on those banks. So, in Megan McArdle's immortal words, "Money is weird. Finance is weird."

I do not think that the FDIC needs to disclose specifically which banks are in trouble. But I do think that there is a lack of transparency about the overall strategy of the Fed and Treasury. In particular, I do not think they are telling us what they don't know. They want us to believe that they know much more than they really do, because they don't want us to doubt their wisdom. In particular, my guess is that in some very important cases they do not know whether institutions face solvency issues or liquidity issues."

Now, I believe that the Fed and Treasury need to be completely clear, especially about implicit and explicit government guarantees, otherwise my Bagehot's Principle Plan won't work.

"An important point is the fact that the financial crisis was not limited to the United States. If you think that the Community Reinvestment Act caused the housing bubble, then explain how it caused the housing bubbles in the UK and Spain.

To put this another way, if policymakers had used the bully pulpit or regulatory policy to stop the bubble in the middle of 2004, does that mean that everything would be fine now? Or would the "global savings glut," as Ben Bernanke famously called it, simply have gone and produced excesses and imbalances somewhere else? In other words, even if you had prevented the housing bubble, would some other bubble have taken its place?"

This one I've talked about many times before and I'll link to them. My basic point, jawboning won't work, and there are other problems as well.

"We got into the question of whether the financial sector had gotten too big in this country. My belief is that it had, in the sense that too many financial institutions and financial instruments are guaranteed by the government, implicitly if not explicitly. Going forward, I think that the plan is to continue to guarantee an immense amount of stuff, but try to regulate more closely. I don't think that's such a good plan. In theory, I like the idea of a finite, guaranteed-and-regulated sector (banks with deposit insurance and tight limitations on activities) alongside a relatively unregulated sector that is more innovative and takes more risk. But in practice we seem to have difficulty both in keeping banks safe and in allowing an unregulated sector where failure is an option. The banks seem to find a way to take risks, and the unregulated folks seem to find a way to get guarantees."

This is gold. I agree with it completely. Where the government has a clearly spelled out guarantee, regulate as needed to protect the taxpayers. Otherwise, use minimal and effective regulation, based on general rules, to oversee the free market. The final sentence says it all. Brilliant.