Democracy failure

But whether and how citizens and their representatives can survive the current onslaught of unchecked power from above is less clear. Culpable governments need to be thrown from office, as has happened in Iceland. Yet monitory democracy - the best weapon so far invented against folly and hubris - must also be strengthened.

It follows from the analysis of democracy failure that blind trust in either markets or government regulators is folly, and that an urgent priority is to find more open and equitable ways of preventing future breakdowns of credit markets, which are bound to remain the drivers - and potential depressors - of markets in general. The question is not just whether governments are too big or too small or whether they work (the words used by Barack Obama in his inaugural address). The question is also whether both governments and market institutions are held publicly accountable for their actions by citizens, and by their various elected and unelected representatives.

The quest to extract folly and hubris from capital markets - to rein in the ruinous power of foolishly inflated expectations - may never fully succeed. The suddenly fashionable vision of “boring banking”, of tightly regulated, low-margin, buttoned-down financial markets, is probably a pipe dream. Risk taking and (broken) promise making in the banking and credit sectors are by definition neither fully predictable nor controllable.

The implication is that capital markets cannot fully be guided by rational calculations that keep things in permanent equilibrium; especially when left to their own devices, private banks and credit institutions will always retain the power to fuel major market movements that take on lives of their own, entrap investors in foolish illusions (Keynes called them animal spirits) that have the effect of seducing other market participants into expecting permanent gains - until feedback signals driven by actual underlying trends puncture the foolish illusions, at which point, as we know to our cost, a boom-bust sequence with incalculable effects takes hold.

Bursting bubbles have regularly plagued market economies since the 17th century Dutch tulip craze; they are intrinsic to unregulated markets, contagious and destructive of human lives. That is why, given the pickle we are in, new early warning systems are urgently needed. More democratic ways have to be found for doing things that central banks, bankers, securities regulators and accounting standards boards manifestly failed to do.

There is of course a feel-good factor when speaking about greater public accountability of markets. Who (aside from some bankers and hedge fund operators) could be against it? The trick therefore is to find toothier ways of clamping down on market failure.

Platitudes about “oversight” and the need for “real reform of our regulatory architecture” (phrases now used by Henry Paulson, Lord Turner and other failed regulators desperate to save their own skins) are simply not good enough. Tough talk needs to be translated into the construction of new monitory bodies. The College of Supervisors and other reforms proposed for the EU by Jacques de Larosière certainly count as examples. Proposals by the US Treasury secretary to set up a new “systemic risk regulator” to supervise hedge funds and traders of credit-default swaps and other exotic financial instruments run in the same direction. So would first-ever global regulatory structures in the fields of banking, insurance and securities - credible forums that would crack down on fraud, discourage excessive risk-taking, foster best practice through open-minded counsel and provide a means by which those hurt by this crisis may seek redress.

At its London summit in April 2009, the G20 acknowledged the pressing need for new global regulatory structures. “The era of banking secrecy is over”, it declared. It agreed to rename and upgrade an obscure close-knit body of central bankers, finance ministries and regulators known as the Financial Stability Forum, whose replacement, the Financial Stability Board, will include representatives from all G20 countries - so making it the prototype of the world’s first financial monitor. Based in Basel and working alongside the IMF, the FSB will have an elevated mandate to “provide early warning of macroeconomic and financial risks and the actions needed to address them”.

For the moment, its officials deny they plan to act like guardians of the global credit system. Their diffidence reflects the fact that there is no formal provision for enabling citizens and independent experts to input their views to the FSB, which will operate entirely at the behest of states, some of which (the United States, China, India) are in any case profoundly sceptical about the need for stronger global-level intrusions into markets.

The secretariat of the FSB is to remain tiny; it has no formal powers to impose anything on anybody; and, for the time being, it will function as a clearing-house advisory and information-sharing body that hosts meetings and sets up “supervisory colleges” that issue reports on “potential risks”, “best-practice principles” and revamped “regulatory systems”. How the FSB would act to avert or resolve cross-border disputes triggered by the future insolvency of troubled companies like Citigroup, AIG and the Royal Bank of Scotland is unknown.

The new FSB will certainly be better than nothing. The proposed EU College of Supervisors and the commitment of G20 governments to clean up domestic banking and credit practices are also promising initiatives. But whether potent and durable monitory institutions within financial markets in fact result from these beginnings, or whether these monitors will be built quickly enough, is for the moment quite unclear. Tough and testing is the road ahead. Just one thing is absolutely certain. Given that the root cause of this crisis is political, the solution has to be political, this time by finding the best remedy for democracy failure in the strengthening of democracy itself.