The natural reaction to market breakdown is to add layers of protection and regulation.  But trying to regulate a market entangled by complexity can lead to unintended consequences, compounding crisis rather than extinguishing them because the safeguards add even more complexity which in turn feed more failure.  Trying harder means sinking deeper into quicksand.   Yet regulators and institutions can’t stand idly by in the face of potential crisis and they certainly cannot know where or how the next crisis will arise, but they learn from their mistakes and develop new or revised regulations and safeguards.  And in a world of increasing complexity, those safeguards add yet more complexity. And so on.

In the face of progress and technological advances that have resulted in stability on many fronts, financial markets, designed to provide a mechanism for managing and addressing economic risk, have developed a structure that has made them inherently more risky.  The irony is that this structure has features that at face value are desirable, in some cases approaching the essential elements of the ideal. As with many ideals, its origin is in academia, in this case a theoretical framework that underpins a half century of work in financial economics.

From a Demon of Our Own Design by Richard Bookstaber

HKO comment:  Bookstaber draws analogies from airline crashes, the Three Mile Island and Chernobyl nuclear disasters and the NASA Challenger and Columbia disasters to demonstrate how excessive safety procedures addressing complicated systems actually contributed to the ultimate disasters in those systems.

Beyond left and right, his analysis of the fault of the regulations to contain the financial meltdown does not stem from a blind ideological commitment to free markets but a carefully considered understanding of the problems of applying complex regulations to complex systems.  We end up fighting the last war and at the same time causing the next one.  The function of the regulation of the financial markets should not be to address the last problem but to reduce the complexity in the system.

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