This is an article by Eliot L. Spitzer, in the Washington Post, explaining why misconceptions about capitalism and free markets have lead – predictably – to Enrons and the financial system’s meltdown. 
This is my favorite quote, and key concept:
"A market doesn’t exist in a vacuum. Rather, a market is a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy."
How to Ground The Street
The Former ‘Enforcer’ On the Best Way to Keep Financial Markets in Check.
Excerpt (read the full article here).
President-elect Barack Obama will soon face the extraordinary task of saving capitalism from its own excesses, much as Franklin D. Roosevelt had to do 76 years ago. Up until this point in the crisis, policymakers have appropriately applied the rules of triage — Band-Aids and tourniquets, then radical surgery — to keep the global financial system alive. Capital infusions, bailouts, mega-mergers, government guarantees of unimaginable proportions — all have been sought and supported by officials and corporate chief executives who had until now opposed any government participation in the marketplace. But put aside for the moment the ideological cartwheel we have seen and look at the big picture: The rules of modern capitalism have been re-written before our eyes.
The new president’s team must soon get to the root causes of the mistakes that have brought us to the economic precipice. Yes, we have all derided the explosion of leverage, the failure to regulate derivatives, the flood of subprime lending that was bound to default and the excesses of CEO compensation. But these are all mere manifestations of three deeper structural problems that require greater attention: misconceptions about what a "free market" really is, a continuing breakdown in corporate governance and an antiquated and incoherent federal financial regulatory framework.
First, we must confront head-on the pervasive misunderstanding of what constitutes a "free market." For long stretches of the past 30 years, too many Americans fell prey to the ideology that a free market requires nearly complete deregulation of banks and other financial institutions and a government with a hands-off approach to enforcement. "We can regulate ourselves," the mantra went.
Those of us who raised red flags about this were scoffed at for failing to understand or even believe in "the market." During my tenure as New York state attorney general, my colleagues and I sought to require investment banking analysts to provide their clients with unbiased recommendations, devoid of undisclosed and structural conflicts. But powerful voices with heavily vested interests accused us of meddling in the market.
When my office, along with the Department of Justice, warned that some of American International Group‘s reinsurance transactions were little more than efforts to create the false impression of extra capital on the company’s balance sheet, we were jeered at for attacking one of the nation’s great insurance companies, which surely knew how to balance risk and reward.
And when the attorneys general of all 50 states sought to investigate subprime lending, believing that some lending practices might be toxic, we were blocked by a coalition of the major banks and the Bush administration, which invoked a rarely used statute to preempt the states’ ability to probe. The administration claimed that it had the situation under control and that our inquiry was unnecessary.
Time and again, whether at the state level, in Congress or at the Securities and Exchange Commission under Bill Donaldson, those who tried to enforce the basic principles that would allow the market to survive were told that the "invisible hand" of the market and self-regulation could handle the task alone.
The reality is that unregulated competition drives corporate behavior and risk-taking to unacceptable levels. This is simply one of the ways in which some market participants try to gain a competitive advantage.
As one lawyer for a company charged with malfeasance stated in a meeting in my office (amazingly, this was intended as a winning defense): "You’re right about our behavior, but we’re not as bad as our competitors."
No major market problem has been resolved through self-regulation, because individual competitive behavior doesn’t concern itself with the larger market. Individual actors care only about performing better than the next guy, doing whatever is permitted — or will go undetected. Look at the major bubbles and market crises. Long-Term Capital Management, Enron, the subprime lending scandals: All are classic demonstrations of the bitter reality that greed, not self-discipline, rules where unfettered behavior is allowed.
Those who truly understand economics, as did Adam Smith, do not preach an absence of government participation. A market doesn’t exist in a vacuum. Rather, a market is a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy.
One of the great advantages U.S. capital markets have enjoyed over the decades has been the view — held worldwide — that there was an underlying integrity to the representations market participants made, because the regulatory framework in which they were made was believed to provide genuine oversight. But as we all know, the laws requiring such integrity are meaningless without a government dedicated to enforcing them.
Second, our corporate governance system has failed. We need to reexamine each of the links in its chain. Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves — all abdicated their responsibilities…
Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions. And the roles of compensation committees, of course, must be totally rethought...
Let’s leave aside the ideological hesitancy that has long hamstrung regulatory agencies. Today’s balkanized regulatory framework for financial services no longer matches in any way the needs of a fully integrated global financial system. The divisions of the past — commercial banking vs. investment banking vs. insurance vs. hedge funds vs. private equity — have become distinctions without a difference. But these old boxes and formalities still determine how entities are viewed and regulated. It should surprise nobody that capital found the crevices in the regulatory framework. That is what capital is paid to do. But we failed to respond with a regulatory framework flexible enough to plug the leaks.
We do not need additional fragmented areas of federal regulation to handle hedge funds, sovereign wealth funds or derivatives…
We began to try to craft such a unified model in New York, as did Treasury Secretary Henry M. Paulson Jr. in Washington last year. But it is urgent that we finish the job. Having flooded the market with cash and seen the government take a chunk of many of our largest financial institutions, we now need to craft the rules that will apply to all market participants.
Three overarching priorities should guide government actions in the new structure. First, we need better control of systemic risk…
…Although mistakes I made in my private life now prevent me from participating in these issues as I have in the past, I very much hope and expect that President Obama and his new administration will have the strength and wisdom to do again what FDR did.
