Is the current financial crisis the result of too little regulation? People asking that question often seem to suppose the total quantity of regulation at issue. If more regulation were always better, then North Korea should have one of the best economies in the world, because surely it is among the most regulated. If it is not that the maximum amount of regulation is best, then it may be that an intermediate quantity produces an optimum. Perhaps too little regulation allows chaos and too much produces strangulation, so that in between there is just the right amount.

If that were so, and the United States were just a bit on the short side of the optimal quantity, then Europe, having more regulation, should be faring better than the U.S. in the current crisis. After all, Europe did not suffer “Bush deregulation.” However the Europeans are worse off. The idea that what matters is the quantity of regulation not viable. If any improvement can be made at all, it must be something to do with the quality of regulation.

Perhaps if we had more brilliant minds in regulatory positions, then problems could be foreseen and new regulations put in effect in time to forestall disastrous consequences. There are several problems with that concept. First, no such brilliant minds exist, and if one came along that person would be unlikely to want to work for the government rather than as an investor. More importantly, it does not suffice that a problem is recognized by a brilliant mind, because both the Executive and Congress must subsequently be convinced to do whatever needs to be done to forestall disaster.

Wall Street has the best minds in the financial world. Anyone who saw the current financial crisis coming could have reaped a fortune from that knowledge. One way to benefit from a market decline is to move asserts into cash, wait until the bottom falls out, and then judiciously buy assets for twenty-five cents on the dollar. Another way to benefit is to sell the market short and collect on the short sales. If any such brilliant minds were running Lehman Brothers, Goldman Sachs, or Merrill Lynch, they could have owned Wall Street. Instead all are deceased.

No doubt someone on Wall Street called the dramatic market downturn correctly. History, unfortunately, shows that the those who call major downturns are rarely able to repeat the feat. Some may have just been lucky. Others may have insights into some situations, but not others.

While no government regulator foresaw the worst, there were some important correct predictions. The Bush Administration foresaw the problems with Fannie Mae et al and asked Congress repeatedly for additional regulatory authority to reign them in. Treasury Secretary Paulsen testified before the House Finance Committee, where he was called incompetent for even suggesting there might be a problem. Calling the problem correctly did no good.

The financial crisis having happened, we are now ready to write regulations that would prevent a repeat of the situation. However, the situation is not likely to repeat, because now the scenario is well-known and everyone is wary of it. The next financial meltdown will be from different causes.

In recent Congressional hearings, a Representative asked a panel of economists from academia what the economy was projected to look like in 20 years. The answer was that there are no models and no projections. I think building macroeconomic models is more likely to help avoid future problems than ad hoc stabs at regulating. Building the models will reveal a need for data to complete the models as well.

For example, leverage is the multiplier obtained on investments. Typically, government-backed mortgages have required a 20 percent down payment. 20% implies a leverage of five to one. With five to one leverage, if two percent of the loans fail, at most ten percent of the total debt would be consumed by the failures. That would be short of a crisis because 20% of the debt would be cash in the bank from the down payments. The surprise in the current crisis was that the leverage in government funded mortgages was not five to one, it was 137 to one. Hence a few percent of failures spelled disaster.

This suggests that the leverage used in investments ought to be disclosed in cases where it is not. That would help investors evaluate risk, and it would feed a math model of the economy. No doubt there are other important data. Most of the data is known, it just isn’t put into models that can be used to assess the stability of the system. The goal should be to make future dangers apparent and certain enough to cause action in advance. If problems were apparent, little government action would be required. Risk-adverse investors would tend to the problems on their own.