The book is somewhat bloated, but the tale is compelling. It starts as Bear Stearns, the smallest of the five Wall Street investment houses, wobbles on the edge of bankruptcy. Treasury Secretary Henry Paulson and the Federal Reserve facilitate JP Morgan’s takeover of Bear, leaving Lehman the smallest of the remaining investment banks. Its stock drops precipitously.

From a huge cast of characters, one man emerges as a tragic figure—Lehman chief executive Richard Fuld. He became obsessed with short sellers (traders who borrow and sell shares to profit from a future price decline), blaming them for spreading malicious rumors about Lehman instead of confronting the bank’s real weakness. That was one in a series of dreadful mistakes. With Fuld’s backing, Lehman president Joseph Gregory had pushed the bank into mortgages, commercial real estate, and leveraged loans. He put inexperienced managers in charge of those activities and got rid of specialists who warned of danger. Catastrophic losses from the real-estate slump were killing Lehman by 2008. Short selling the stock was a symptom rather than a cause of the disease.

Sorkin recounts Lehman’s destruction, which occurred despite Fuld’s increasingly frantic efforts to raise capital or sell the company. Bank of America bought Merrill Lynch instead of Lehman, with the blessing of the Treasury and the Fed. A deal was worked out with Barclays Capital but scuttled at the last minute by British regulators, a debacle their American counterparts could almost certainly have prevented.

Timothy Geithner, then head of the New York Federal Reserve, was fixated on merging other banks. During a tense phone call, he effectively ordered Morgan Stanley chief John Mack to sell his company to JP Morgan for almost nothing. “I just won’t do it,” Mack said and hung up. There was no good business reason for the merger, and JP Morgan chief Jamie Dimon did not want it either.

Mack managed to save Morgan Stanley by getting capital from the Japanese bank Mitsubishi. Had Geithner succeeded in bulldozing Mack into selling, tens of thousands of employees would have lost their jobs and the too-big-to-fail problem would have been exacerbated. The incident does not inspire confidence in Geithner, currently Treasury secretary.

Another bad shotgun marriage was arranged by Sheila Bair, head of the Federal Deposit Insurance Corporation, who decided to sell Wachovia to Citigroup with a government guarantee for toxic assets. Fortunately, Wells Fargo chief Richard Kovacevich, who was interested in Wachovia all along, took action just in time. Wells Fargo was willing to pay a higher price without a taxpayer guarantee.

These events raise the question of why government agents can dispose of other people’s property. They certainly don’t seem to worry about preserving the value of businesses or reducing taxpayer liability.

What’s the lesson in this? Unfortunately, Sorkin doesn’t make the big picture clear. The boom-and-bust happened because the Fed opened the floodgates to easy money. That’s what got everybody, from the second-mortgaged homeowner to Lehman Brothers, to leverage up. Our supposedly expert government players apparently never realized this: Their conceit that they know how to manage the economy is the root of our trouble.

They might avoid fueling bubbles, but let’s leave that aside, since Sorkin doesn’t dig that deep. He describes interventions notable, among other things, for their sheer arbitrariness. The Fed and Treasury backstopped Bear Stearns debt in the acquisition by JP Morgan, but would not do the same for Lehman. The first action created expectations that the same support would be available for other banks and led to a false sense of security. There is no obvious reason why two sets of bond holders should be treated differently. It would be vastly better if government officials were deprived of the authority to bail out anyone.

Our financial system has suffered tremendously as a result of capricious interventions by government officials who themselves never bear any costs from the adverse effects of their decisions. If anything, they benefit. Though the entire boom-bust cycle provides evidence that government agencies, from the Fed on down, should have far less discretion, the massive financial regulation law passed this year rewards them with greater powers and wider room to do whatever they want. We should be afraid of the economic and social damage their arbitrary actions will wreak in the future.

Meanwhile, Congress put the finishing touches on a mammoth regulatory bill called the Restoring American Financial Stability Act of 2010. (Editor’s note: It was passed and signed in mid-July.) As I write there is no way to know what final shape it will take. But considering how it was shaping up, what are the probable effects?

The rationale for this vast expansion of government oversight is to prevent, or at least reduce, financial instability, as the bill’s title declares. Therefore it is useful to remind ourselves of why and how markets became so unstable in the first place.

There are two fundamental reasons why markets gyrate. One is human emotion, in particular a penchant for over-optimism about financial prospects, which turns into panic once things go downhill—a pattern known colloquially as greed and fear. Business cycles are unavoidable to the extent they’re rooted in human behavior. On top of this, governments have caused normal cycles to become extreme and destructive with a multiplicity of interventions and their own financial woes—as with Greek sovereign debt.

Thus the boom in the American housing market was set off by optimism that property prices would keep rising and the bust initiated by the panic that ensued when prices faltered. But the cycle became monstrous because the Federal Reserve kept money creation too loose in 2001–2004. To make matters worse, Congress pushed the two government-created entities, mortgage buyers Fannie Mae and Freddie Mac, to go easy on less creditworthy loans.

As a result of these policies, taking out a mortgage became child’s play. People who might have otherwise been more prudent mortgaged up to the hilt, and enormous piles of mortgages became available to be bunched together and turned into securities—a lucrative activity that drew the attention of Wall Street, but was done largely by Fannie Mae and Freddie Mac.

When real estate turned, it took down banks that lent heavily to developers, homeowners who borrowed beyond their means, and financial companies that held or insured mortgage-backed securities. As for Fannie and Freddie, they continue to suck down billions of dollars of taxpayer money every month, with no end in sight.

Human nature has not changed, and the government is becoming more interventionist, not less so. So the conditions that produced the dramatic bubble-and-bust remain in place. How, then, will the Financial Stability Act prevent crises?

Since it is not practical to analyze all the disparate elements that constitute a 2,300-page grab bag of a bill, I will focus on the centerpieces that were most likely to become law. These are from the version of the bill introduced April 15, sponsored by Sen. Christopher Dodd.

The first is the creation of a supra-bureaucracy called the Financial Stability Oversight Council, with nine voting members who are to make decisions by majority vote. Among them are the Treasury secretary, the Federal Reserve chairman, the Securities and Exchange Commission chairman, the director of the Federal Housing Finance Agency, and an independent member appointed by the president.

Almost all council members are heads of departments and agencies that have been around for decades and shown not the slightest ability to prevent risky behavior by financial firms, the population at large, or for that matter themselves and fellow government entities. Somehow, they are supposed to do together what they don’t do on their own.

The act also adds a new bureaucracy, the Office of Financial Research, with responsibility to collect and process data and conduct studies for the council. This newly created apparatus of the council and research office is to work as “an early warning system to detect and address emerging threats to financial stability and the economy,” according to a congressional committee report.

The research office would get the power to subpoena information from any financial company. It is “to develop and maintain metrics and reporting systems for risks to the financial stability of the United States” and “monitor, investigate, and report on changes in system-wide risk levels and patterns.”

If you ask what the systemwide risks are, you won’t find an answer in the act. The director of the office, appointed by the president for a six-year term, “shall have sole discretion in the manner in which” he or she exercises the authority provided by the bill. Indeed, the wide discretion the bill provides to future bureaucrats is remarkable. What they’re going to do to promote stability is about as clear as how snake oil was supposed to cure cancer, bunions, and lovesickness.

The act says certain bank companies may be required to have a “risk committee” with “at least one risk management expert having experience in identifying, assessing, and managing risk exposures of large, complex firms.” That is like requiring water to flow downhill. Almost every financial business already has risk control people. Even hedge funds have risk managers.

Risk management is a well-established discipline with an ever-increasing number of practitioners who spend their time trying to measure and reduce future hazards. In finance the number of risk management experts has grown tremendously in past years—without any legal mandate. These specialists have been notably unsuccessful in preventing occasional crises, as the past several years demonstrated.

Risk experts constructed the mathematical models that gave misleadingly benign views of the dangers in mortgage-related complex instruments. The models will improve over time, but will occasionally be mistaken regardless of legal requirements. It is not the case that financial companies want to lose money.

The basic reason they sometimes do lose money is that making money requires some risk. This is no different from many other activities, such as drilling for oil. Yes, you can end up with a nasty spill, but no risk, no oil. Similarly, no financial risk, no financial gain.

The object is not to avoid risk but rather to keep it under control, and that has always been a most delicate task. The early twentieth-century economist Frank Knight made a distinction between risky situations, where the possible outcomes and their odds can be estimated, and uncertainty, where there is no meaningful way to know the probabilities. There are known unknowns and then there are unknown unknowns.

Throwing dice exemplifies risk with known odds. By contrast, Fannie Mae (which, along with Freddie Mac, is unaddressed in the new law) is a source of uncertainty; the consequences of its creation were unexpected, and its future is an unknown unknown at this time. It stands as a shadowy but colossal monument to man’s ability to create monsters in the name of doing good.

Dealing with risk is hard enough; we’re lost dealing with uncertainty. This shows up especially with rare but big events—known as the tail risk of a bell-shaped probability distribution. More vividly, Nassim Nicholas Taleb, a trenchant critic of financial industry practices, has dubbed them black swans.

As long as an event like the real estate slump has not yet happened, people make money by ignoring it. Therefore risk managers “play politics, cover themselves by issuing vaguely phrased internal memoranda that warn against risk-taking activities yet stop short of completely condemning [them],” to quote from an earlier book by Taleb, Fooled by Randomness, published a decade ago—when risk managers were already recognized players.

Same Goes for Government

This criticism applies no less to government agents. Nobody has a reliable way to predict rare events, and human nature is all for ignoring them. Regulators don’t do any better—from the chairman of the Federal Reserve on down, officials issue vague warnings but don’t stop risk-taking. After all, they are subject to the same behavioral biases and face similar incentives. Just as shareholders are displeased when a bank does not make money, voters are displeased when a government imposes economic hardship.

Therefore, like banks, governments keep dancing as long as the music lasts. It is hard to imagine that changing. So preventing future crises is the least likely outcome of the Stability Act. But might it have some other benefit?

Emergency measures used by the U.S. Treasury and the Federal Reserve to prop up companies in 2008–2009 left in their wake the absurd problem of too-big-to-fail—taxpayers appear to be on the hook for any large financial concern whose failure might have far-reaching impact. Given that taxpayers also ended up with the vast pension liabilities of General Motors, the problem of bailouts is not really confined to financial companies, though it is widely described as such.

Nobody wants a repeat of the widespread panic and losses caused by the bankruptcy of Lehman Brothers in September 2008. That failure resulted in market chaos in large part because the assets of Lehman clients got tied up in bankruptcy courts, not just in the United States but in the United Kingdom. With their capital frozen in years-long litigation, the clients sold securities to raise money, with the predictable catastrophic effect on prices.

So instituting a process by which large financial companies can be shut down without a lengthy bankruptcy case would both reduce the impact of failures and get rid of the notion that investment banks need to be bailed out. Expeditious, orderly, and internationally coordinated winding down of failed companies is an obvious solution for the too-big-to-fail problem.

The act gives the Treasury, in conjunction with judges from the U.S. Bankruptcy Court for the District of Delaware and other agencies, broad powers to take control of a financial business perceived as a threat to the system and turn it over to the Federal Deposit Insurance Corporation (FDIC) for liquidation. The FDIC, which unwinds failed commercial banks, is to do the same for other financial businesses.

“Once a failing financial company is placed under this authority, liquidation is the only option; the failing financial company may not be kept open or rehabilitated,” says a Senate committee report.

That may sound like a way to prevent bailouts, but the government is given such open-ended discretion that perverse outcomes are possible. To go this liquidation route a company does not need to be actually in default as long as the Treasury determines that it is a sufficiently serious threat. On first read, my primary concern was that companies that were not going to fail might be liquidated.

On second thought, it is just as possible that those which are failing will be bailed out instead of being liquidated. This could happen if there are politically powerful interests behind a company. Think of the unions that came out on top in the government’s handling of GM. In effect, we’re asked to trust politicians and bureaucrats. No doubt they will make politically advantageous decisions, with goodies for the politically favored and sticks for the politically vulnerable.

A better alternative to the creation of this extensive authority would be to streamline bankruptcy to make it simpler and faster. The act calls for studies of bankruptcy and international coordination, the latter of which is necessary because large investment banks are global entities—but the possibility of bankruptcy reform is remote. That could reduce legal fees, not something that a Democratic Congress will allow. Lawyers are a major constituency for the Democrats. They will be among the big winners of the regulatory onslaught, which is bound to increase the demand for legal services.

More Of The Same

It is ironic that the act expands the government’s domain in the name of stability, since public policies have increased instability, public functionaries have been clueless in foreseeing threats, and politicians have created uncertainty—with Fannie Mae, for instance.

One of the members of the Stability Council, the Federal Housing Finance Agency, was set up by a 2008 law to be the successor to the Office of Federal Housing Enterprise Oversight. The latter, the overseer of Fannie and Freddie, presided over debacle after debacle, year after year, from accounting shenanigans to endless taxpayer bailouts. Congress obviously wanted an agency with a different name.

But the new bureaucracy is simply the old one merged with another entity. So the same bureaucrats that did so well ensuring the safety and soundness of Fannie and Freddie are supposed to ensure financial soundness on a wider stage in the new setup! If that does not inspire confidence, neither do other members of the council.

The Securities and Exchange Commission let Bernard Madoff continue his Ponzi scheme year after year despite repeated complaints from a whistleblower and even news stories about the fraud. More recently another astounding SEC failure came to light.

In 2009 Texas resident Robert Allen Stanford was nabbed for an $8 billion fraud—Stanford International Bank had for years sold certificates of deposit promising unachievable returns. An investigation found that the SEC Fort Worth office had known since 1997 that Stanford was likely operating a scheme. Despite examinations indicating this, the enforcement division chose not to take action.

The preferred excuse for numerous government debacles is that the bureaucracies lacked authority, personnel, or information. Yet the SEC in fact repeatedly examined Stanford and had the power to stop his activities.

Here is the punch line to the Stanford affair. In a dramatic instance of the revolving door for former regulators, the SEC lawyer who made enforcement decisions at Fort Worth left and represented Stanford—before he was told that this was improper. That’s how regulation works in reality.

Expanded Crony System

The vast new powers given to regulators will no doubt enhance the fees and salaries that former bureaucrats like this SEC lawyer command. They will have greater opportunities to sell their protection and expertise to the regulated and will also, of course, benefit from enlarged budgets while in public employment. Politicians and political staffers, too, will be able to extract more money from the regulated and get lucrative jobs in the financial industry.

This is already an established trend, with President Obama’s former White House counsel moving to Goldman Sachs and a former aide to Rep. Barney Frank on the House Financial Services Committee taking a job with a derivatives exchange. Such crossovers will no doubt become even more common as firms look to protect themselves while government agents get a broad mandate to intervene and decide which companies to liquidate and which to bail out—who’s a systemic risk and who’s not.

Even as they go “tsk-tsk” chiding business lobbies, the President and Congress are laying the groundwork for an infinite growth in the crony system intermingling government with private interests. The rest of us will pay for the resources that will be redistributed in favor of bureaucrats, politicians, lawyers, and the politically favored. The impact of the act on financial stability is uncertain at best, but its corrupting influence on the Republic is a sure thing.

Posner describes well-known events—the failure of investment banks Bear Stearns and Lehman Brothers, the series of bailouts by the Treasury and the Federal Reserve, the stimulus package passed by Congress—then tries to explicate the causes of the crisis. His account, unfortunately, merely hews to current conventional wisdom.

Here’s a capsule version: Deregulation of banks combined with cheap and easy credit to cause interlinked debt and real estate bubbles. “Free market ideology” left banks and other financial firms free to take huge risky bets on mortgages, which they did. In 2007–08 the twin bubbles collapsed, resulting in a steep downturn in economic activity. The government had to shore up the system with extraordinary measures. The long-term solution is more government action to restrain and supervise financial institutions, although Posner would wait until the dust settles before reregulating.

It’s true that some household borrowing was channeled to risky instruments like adjustable-rate mortgages and much of the lending by banks was turned into complex securities backed by debt. When property prices declined and foreclosures spread, the values of these securities also declined, decimating bank balance sheets. But all that is a consequence not a cause of the trouble.

At the heart of the story is the ready availability of credit that fueled excessive borrowing and lending. Posner describes how the Fed flooded the economy with money in the early 2000s in response to the collapse of the previous bubble in stocks. However, he claims that even without the Fed’s loose monetary policy, an alleged global capital surplus brought in enough money from abroad to keep interest rates low.

That claim is dubious. Yes, Asians saved a lot, but other people, notably Americans, saved relatively little. In the world as a whole there was no surge in saving to drive down interest rates. It was the Fed’s easy money that pushed markets into a credit binge.

Posner’s line is that “Laissez-faire capitalism failed us, but government allowed the preconditions of depression to develop and wreak havoc with the economy.” He discusses the Federal Reserve’s culpability for the crisis, granting that it “would be a powerful argument against re-regulation,” but places more blame on that hobgoblin, “free market ideology.” The “free market” canard requires one to ignore that the United States hasn’t had anything close to a free financial market in a century.

Major mistakes by experts pose a challenge for Posner’s way of looking at behavior. For example, he describes Fed Chairman Ben Bernanke’s neglect of the warning signs of an impending crash as “extremely puzzling.” As a proponent of neoclassical economics, Posner assumes that people act rationally in the sense of making the best choices in view of all available information. And the Fed must be even more rational than the rest of us.

Another academic tribe, behavioral economists, attributes the crisis to human quirks like herding or imitation. Posner rejects those explanations on the ground that such behavior is not really irrational. On regulatory issues, however, he does not differ from behavioral economists who assume that government experts are trustworthy because they’re better informed than the general population.

Long before the currently fashionable behavioral school emerged, F. A. Hayek criticized the neoclassical rationality premise but came to a different conclusion from today’s proregulation behavioral economists. He found that government agents possess less wisdom than the market, which pools the knowledge of many individuals. The “fatal conceit” (as Hayek put it) that government knows better has resulted in economic disasters ranging from the Soviet Union to the Federal Reserve’s destabilizing policies.

Now the Fed is to become an even more powerful regulator of vaguely defined “systemic risk.” Posner grasps that “The successive Federal Reserve chairmanships of Greenspan and Bernanke must be reckoned prime causes of the financial crisis,” but even so agrees with President Obama that more government intervention is needed.

As a reform, Posner advocates the consolidation of agencies like the Securities and Exchange Commission into one top regulator along the lines of Britain’s Financial Services Authority. He appears oblivious to the fact that this authority with its overarching powers did not save Britain from financial crisis.

This highlights the book’s great flaw: Posner clings to the myth of benign government rationalism.

To be sure, financial firms leveraged up—that is, they did a lot of business with borrowed money. That juiced up revenues and bonuses in the boom—and exacerbated losses in the downturn. Selling notes based on questionable mortgages as collateral was one method for tapping into the money sloshing around.

Without abundant credit, it would not have been possible to borrow so much and in so many different ways. Banks create credit but are subject to myriad controls by the Federal Reserve System. Money was plentiful because of Fed policy.

Politicians, pundits, and the Obama administration want to impose new regulation on the financial system, giving wider powers to government agencies. Depending on how and to what extent they implement that agenda, the Federal Reserve—alongside other agencies like the Securities and Exchange Commission—stands to gain greater authority. Hence the Fed’s track record is a timely and pertinent subject.

Although the institution now commands unquestioning acceptance, its inception was controversial. Richard Timberlake, in his history of monetary policy in the United States, quotes a congressman shortly after the 1913 passage of the law that created the Federal Reserve System: “This act establishes the most gigantic trust on earth, such as the Sherman Antitrust Act would dissolve if Congress did not by this Act expressly create what by that Act it prohibited.”

That gigantic trust has correspondingly gigantic effects on the economy, through multiple roles and powers. As overseer of ordinary banks the Fed makes sure they play by the rules. As lender of last resort it can keep banks going through cash-flow problems. Beyond its supervision of individual banks the Fed pursues economy-wide goals.

It operates various levers that reduce or expand the supply of money and credit. In what is generically called monetary policy, the Fed uses the levers to boost a drooping economy—as is happening at present—or cool down an overheated one. In theory those efforts benefit society at large.

In reality—well, let’s take a look at the 1930s and our own time to understand the Fed’s role in the two most dramatic financial crises of living memory.

Stability Found and Lost

Two seminal insights emerged from the path-breaking A Monetary History of the United States, 1867–1960 (1963) by Milton Friedman and Anna Schwartz. They argued that the Federal Reserve worsened the banking collapse of the 1930s and probably killed off a potential recovery by tightening money. In reaction to a drain on U.S. gold reserves, the Fed clamped down on an already shrinking money supply, thereby turning an ordinary recession into what came to be known as the Great Depression.

Current Fed Chairman Ben Bernanke agrees with that conclusion and is certainly not repeating the mistake. He has eased money in every way it can be eased.

But Friedman and Schwartz offered a broader lesson as well. They showed that the stock of money became subject to greater fluctuations after the Fed took over the control of money from the gold standard system. “The blind, un-designed, and quasi-automatic working of the gold standard turned out to produce a greater measure of predictability and regularity—perhaps because its discipline was impersonal and inescapable—than did deliberate and conscious control exercised within institutional arrangements intended to promote monetary stability,” Friedman and Schwartz wrote.

By the late twentieth century it looked as though central bankers had taken this criticism to heart. They had reason to congratulate themselves on what was called the Great Moderation. Since the mid-1980s both prices and output growth had been reassuringly stable. In a 2004 speech Bernanke argued that this was primarily due to improved monetary policy, although economic change and plain old luck also may have played a role, too.

At that time Bernanke was not yet Fed chairman, but he was a member of the board of governors, a position he held from 2002 to 2005. Current Treasury Secretary Tim Geithner was president of the New York Federal Reserve Bank from 2003 until this year. These facts are worth recalling because there is a tendency to concentrate the blame on former chairman Alan Greenspan. But whatever one thinks of Greenspan, the officials who currently make policy were there with him as the Fed sowed the seeds of financial crisis.

In retrospect those seeds were already discernible in the late 1990s. The steep rise in housing prices had started, encouraged by a stock bubble that created the illusion of wealth. In 1998 the Fed eased interest rates several times in response to panic after Russia defaulted on its bonds and the related near-failure of a large hedge fund, Long-Term Capital Management. This policy reassured investors, who subsequently bid up share prices to the stratosphere in 1999 even as the Fed reversed course.

The stock bubble burst in early 2000, and the economy stalled. Interest-rate cuts are prescribed and expected in a recession, so it is no surprise that the Fed took that course. But even after the economy recovered, rates stayed exceptionally low in comparison to what they would have been by the standard of the Great Moderation.

Stanford University economist John Taylor has used a measure known as the Taylor Rule to demonstrate that monetary excess lasted several years, into 2006. The title of Taylor’s new book says it all: Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.

Not everybody agrees that monetary policy was loose during the Greenspan era. David Henderson and Jeffrey Rogers Hummel argued in the March issue of The Freeman that monetary policy was not expansionist from 2001 to 2006 as measured by the declining growth of monetary aggregates. The Taylor Rule, however, allows the comparison of two periods—and the federal funds rate was lower in the 2000s than in the 1980s.

Another explanation of the monetary excess, endorsed by Bernanke and Greenspan, is that there was a global glut of savings. But Taylor shows that worldwide there was no such glut because the surplus savings in Asia and the Middle East were offset by a savings gap in other countries, in particular the United States.

It is fair to say that most of us partook of the Fed’s generous punch, whether by running up credit-card debt, buying houses beyond our means, trading with borrowed money, or making 30 percent on exotic debt instruments. Monetary excess meant that borrowing was easy; mortgages were to be had for a song. Housing prices rose at amazing rates year after year. With the hazard of price declines out of sight and out of mind, homeowners, developers, and banks overextended themselves.

It was an extraordinary boom; hence the following bust was also extraordinary. In effect, the stability of the 1980s Great Moderation was over by the time Bernanke credited monetary policy for fostering that stability.

What Failed

The bubble-and-collapse sequence is now attributed to a failure of capitalism, to use the title of a new book by Richard Posner, a judge and prolific author. According to a widely held view, the private financial system is intrinsically unstable, with leverage a central element in its penchant for self-destruction. Had the system been properly regulated and restrained, it would not have gone haywire. Hence whatever is not sufficiently regulated should be nailed down to avoid similar disasters in the future. Much of the media reflects that view.

And yet the Fed and the Securities and Exchange Commission (SEC) between them already have massive regulatory powers over banks and broker-dealers, including investment banks. What is more, they and other agencies were part of the President’s Working Group on Financial Markets, set up after the crisis of 1998 to deal with systemic risk—the kind of danger that came up so frequently in 2007–2008.

Despite all the regulatory powers, a crisis broke out. Posner may represent current conventional wisdom when he writes that the government’s myopia, passivity, and blunders played a critical role in allowing the recession to balloon, but there would have been a crisis anyway regardless of those shortcomings.

The alternative view, represented by Taylor (following in the footsteps of Ms. Schwartz and the late Mr. Friedman), is that monetary policy turned what might have been mild cyclical fluctuations into a big bubble, inevitably leading to a big collapse. No easy money, no crisis.

Regarding the central bank’s multiple functions, its stance in the supervision of individual banks appears to have been of a piece with its broader policy. The Fed as overseer of banks could have demanded that they reduce their use of leverage, but the Fed as maker of monetary policy was providing the wherewithal for that leverage.

Hence the let-them-leverage regulatory stance was not accidental or myopic; it was consistent with deliberate monetary policy. If policymakers were concerned about the galloping credit expansion, they should not have let money go loose in 2003–2006. Lacking such concern, the Fed had no reason to get banks to reduce their risk. The whole institution took this track, not just Alan Greenspan.

Controlling or Creating Risk?

There’s no question private action results in economic cycles, largely because human beings have mental biases that keep them focused on the near term. The key point, though, is that even the largest private actor does not have the impact of the gigantic banking trust. Monetary policy is system-wide; policy mistakes have ramifications across the economy.

So the Fed by itself can create systemic risk, even as people call for expanding its powers to control the systemic risk posed by market participants like banks and hedge funds.

The Fed actively implemented measures that destabilized the system in the 1930s and again in the 2000s, albeit in different ways. The mistake was different—back then the Fed tightened in a downturn; this time it kept money too loose in an upturn. But there was the same fundamental consequence of financial and economic instability.

Timberlake thus summarized the Federal Reserve’s track record: “It comes across as a prototypical governmental institution operating under the rule of men rather than the rule of law.” To prevent misguided monetary interventions, the discretion of the people who run the institution should be limited.

Friedman argued for rule-based monetary policy, specifically that the Fed should follow a rule to keep the money supply growing steadily at a fixed rate of 3 to 5 percent a year. This turned out to be difficult to implement, given that the money supply and its relation to the economy are complicated.

This is where the Taylor rule, which describes actual policy during the Great Moderation, comes in. Taking that policy as a template, the Fed can set the short-term interest rate in accordance with a constant formula based on inflation and output.

Compared to Friedman’s fixed rate, the formula is more flexible.  But it keeps interest-rate policy predictable and transparent. If followed consistently, rule-bound monetary policy, combined with proper enforcement of existing regulations for banks and broker-dealers, would prevent the excesses seen in recent years.

Government Intelligence and the Nirvana Fallacy

Instead, what’s being advocated is broader activity by policymakers. Posner, for instance, draws the conclusion that “we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.” It is interesting that he sees a need not just for more-active government but more intelligent government. If government action has not been intelligent in the past, why expect it to be intelligent in the future?

We’re talking about institutions with overarching powers that have caused a variety of harms, from deliberate Fed policies that created instability to the SEC’s inability to detect fraud even after being told about it, misleading investors into believing that all was well with Bernard Madoff. (See my May Freeman article on the Madoff case) If there is more government activity of this sort, there will be even worse disasters.

One way to prevent another round of government-made debacles would be to replace the central bank with market-based money, thereby imposing an impersonal discipline—to use the words of Friedman and Schwartz. But following the Taylor Rule is a more likely solution, since it serves the goal Fed officials themselves say they want to pursue, namely, more predictable and transparent policy.

Those calling for greater interventionism tend not to engage the issue of what the government does in reality. There is a presumption that regulation is the cure-all, even as we live through the effects of a systemic policy failure. Economist Robert Solow, in a review of Posner’s book, writes that Panglossian ideas about “free markets” encouraged lax or no regulation of a potentially unstable financial apparatus.

When you consider the actual role of the Federal Reserve in crises, it is the notion of government activism as the solution to financial uncertainty and fluctuations that comes across as Panglossian.

With deregulation fingered as the culprit, the new occupants of Congress and the White House are expected to infuse regulatory bureaucracies with greater authority and resources.

Commentators cite the Madoff affair as proof positive against the free market. “The long, bipartisan experiment with financial deregulation has failed utterly,” declared Tim Rutten in the Los Angeles Times. “The Madoff scandal should be a wake-up call,” wrote Arthur Levitt in the Wall Street Journal, calling for more regulation of investment advising.

Levitt headed the Securities and Exchange Commission from 1993 to 2001—a period that covers the early stage of the debacle—and knew Madoff personally. He says he did not suspect wrongdoing.

In this case, as in an earlier fraud case I’ve studied, regulators in effect facilitated the deception. People made mistakes in part because of the assurance provided by government oversight. It is remarkable that a massive government failure of eight or nine years’ duration has turned into an argument for market failure and more government.

Bernard Madoff Investment Securities was a major broker-dealer that executed a large number of trades on the Nasdaq and made markets for certain securities. Madoff, a pioneer in electronic trading, had helped build the Nasdaq electronic market. He was so well respected that regulators would ask his opinion about the trading system.

As a brokerage the firm was heavily regulated by several agencies, with the SEC as the primary overseer. Besides mediating trades, Madoff traded with other people’s capital. He appeared to be unusually successful at this, making around 15 percent annually over a couple of decades with nary a losing year.

There were rumors about those stable profits. How could it be that this one man made money during times when others used the same strategy, traded the same securities, and made losses? An obvious explanation was that Madoff exploited his market-making position, from which he knew when there were significant purchases or sales that could raise or lower the price of a security. Taking advantage of the information, he could buy or sell ahead of the trades his brokerage executed. This would give him a huge edge over other traders and explain the exceptional steadiness of his returns. He could not tell people this was the source of his profits, though, since “front-running,” as it is known, is illegal.

The other explanation was that he was not making the returns he claimed to make—he was engaged in a garden-variety fraud often called a Ponzi scheme. He may have made money initially by front running but stopped doing that because he feared getting caught. Later he fell into the scheme of fabricating returns and paying some investors with other investors’ money. Only Madoff knows what happened.

In any event, his beyond-belief performance was brought to the attention of the SEC and other agencies by at least two people acting independently. One wasa hedge fund manager named Michael Berger, who was himself apprehended for concealing losses from investors in Manhattan Investment Fund.

In an attempt to get leniency from the government, Berger in early 2000 offered the SEC, the FBI, and the U.S. Attorney’s office information about Madoff and other dubious ventures. He told me and other journalists about this. In 2001 and 2002 several articles appeared in the press expressing doubts about various aspects of the Madoff operation.

Authorities had already heard about the matter from Harry Markopoulos, an analyst and trader frustrated because he failed to achieve the robust returns Madoff reported. Markopoulos used quantitative analysis to demonstrate that Madoff could not make the returns he claimed with the derivatives trading strategy he said he used. Starting in 1999 Markopoulos repeatedly discussed the matter with government officials and even submitted a report documenting his case.

The SEC investigated Madoff Securities several times. The examiners found minor violations of a technical sort but no big problem. Madoff paid a fee, fulfilled a requirement to register as an investment adviser, and was allowed to go on his way.

People who invested their own or their clients’ money with Madoff saw the press reports and heard about the SEC examinations. For instance, a Swiss bank that channeled capital to him had concerns, but according to an internal letter the executives “found comfort” that the brokerage was subject to routine audits by the SEC and FINRA, a nongovernment industry regulator.

Regulators discovered no fraud after repeated complaints and inspections. That reassured investors and aided Madoff’s game, which was officially recognized only after he confessed in December 2008—after, possibly, decades of cheating.

The Usual Fiasco

This regulatory fiasco is not unique. Berger had a similar pattern, as I show in the Winter 2009 issue of The Independent Review. Berger was able to hoodwink investors, accountants, and auditors for three years partly because an SEC-regulated broker-dealer backed him up.

These government failures are not due to lack of regulatory laws, authority, or personnel, despite an understandable campaign to make it look that way. SEC examiners had every authority to look into any aspect of the Madoffoperation. Markopoulos, the analyst, offered his services to the government to help uncover Madoff’s fraud. IfSEC staff lacked the skills, they could have employed Markopoulos or another consultant.

Some argue that the United States needs a unified, stronger financial regulator to prevent such occurrences. Yet major frauds happen in countries such as France, where the regulator is as powerful as can be. Levitt complains that the SEC does not have enough resources. Yet it appears that plenty of resources were in fact spent on the Madoff matter.

The truth is that government agents are subject to the same cognitive weaknesses and biases as market agents and make the same mistakes. Madoff’s investors took their cue from one another—as did people in other schemes. Government agents joined in the herding behavior and encouraged the delusion by exonerating Madoff of serious accusations.

Reducing the incidence of fraud requires investors to be more skeptical and alert to early signs of trickery. It requires better awareness of the mental biases we all have, which make people easy marks to smart manipulators. But the popular image of government bureaucrats as wise guardians taking care of the rest of us creates a false sense of security—a cognitive hazard that makes investors more vulnerable.