"let us not lose faith in market mechanisms to provide solutions"

Burton Malkiel gives the real answer right off the bat in the FT, and then veers off into a mechanistic explanation, i.e., it's the investments:

"As the world economy struggles to recover from the worst financial crisis since the Great Depression, we are reminded of the fundamental truth that every financial system depends on trust."

Trust. Very good.

"Market participants need to believe that the counterparties they deal with will fulfill their obligations. That trust has been severely damaged as our financial institutions have suffered life-threatening, self- inflicted wounds by purchasing over a trillion dollars of complex mortgage-backed securities, secured by dicey loans and financed on the thinnest of margins with short-term debt."

Problems:
1) Poor loans
2) Too little capital

All done? No.

"There is widespread understanding that the long-run solution must involve substantial deleveraging and recapitalization of our financial institutions. But there is also a popular view that the government should effectively regulate complex derivatives out of existence and impose stringent limitations on executive compensation to curb what critics have described as “the pervasive greed on Wall Street.”

Here, we agree. We need to deleverage and recapitalize, but not micromanage these investments.

After giving a good description of why CDS's are good investments, he says this:

"One problem was that the market mushroomed out of control. One could buy a CDS not only on bonds you owned but even on bonds you didn’t own. Speculators might bet that some risky company might default on its bonds even if they did not own the bonds. Hence the volume of CDS instruments became a multiple of the total value of the actual bonds that were being insured. In fact, the CDS market at its peak totaled over $60 trillion, far larger than the total bond market and almost four times larger than the total capitalisation of all the stocks traded on the New York Stock Exchange."

Now, using the great knowledge of Derivative Dribble, I can say that:
I don't consider these CDS's here mentioned investments, in my sense, so I wouldn't buy them, but they are useful for assessing the likelihood of investments defaulting. So they can have a use, even for someone who doesn't invest in them, like me.

"The CDS market linked financial institutions in such a way that systemic risks to the whole financial system were magnified. "

There's no reason that this can't be measured like disaster insurance is.

"What we need is a shift from the current over-the-counter bilateral CDS market to an exchange-traded market. Contracts should be more “plain vanilla” and standardised. They should be fully collateralised and traded on a central exchange. A central clearing house, backed by capital contributions from the clearing members, should guarantee all contracts. The counterparty for each contract would be the clearing house. Contracts should be marked to the market at least daily and probably even more often. The transparent pricing and volume information provided by exchange trading should eliminate the opacity in the current system. While the new market may well reduce the profitability of current market participants, the advantages of greater liquidity, transparency, and safety should help make the entire financial system stronger, less opaque, and more trustworthy. Already the CME and ICE exchanges have been preparing plans for a CDS market based on these principles."

I agree with all this, but it's already been dealt with by poor loans and more capital.

"The second problem requiring a long-run solution concerns the perverse financial incentives inherent in the current system. It too can be handled without government-mandated compensation limits. Under present arrangements, executives of our financial institutions are often paid extremely large cash bonuses based on their attainment of annual profit goals. It is basically the same system by which hedge fund managers earn incentive payments amounting to a fixed percentage of the funds’ profits."

I would think that real moral hazard and fraud and fiduciary negligence would be more useful than limiting pay, but I do agree with limiting pay. I simply believe these individuals aren't worth the money they're receiving. Period.

"While there have clearly been market failures involved in the current crisis, let us not lose faith in market mechanisms to provide solutions. The US financial markets are the most flexible and innovative in the world and, for all their current problems, they have helped make America an innovation machine. Weakening those markets to calm short-term disruptions would be a serious mistake."

Can't disagree with that. Once again, the problem was solved very easily right at the beginning of the post.