Stephen King: From Pope Pius VII to the credit crunch, market failure lives on

Early in the 19th Century, Pope Pius VII decided to clean up bits of Rome. In particular, he took exception to the squalid nature of the Piazza della Rotondo. In a modest way, his ambition can still be seen today. Opposite the Pantheon, there's a plaque on the wall carrying a Latin inscription. Translated, it says that, by means of "demolition", Pius was to rid the square of its "disliked ugliness". He particularly objected to the "ignoble" shops and restaurants which ruined the Pantheon's surroundings. He ordered, instead, the creation of a pleasant open space.

His problem, of course, was that the Pantheon is one of the most remarkable buildings in a truly remarkable city. Remarkable buildings, in turn, attract hangers-on, leading to the "disliked ugliness" which met with the Pope's disapproval. The hangers-on are, in turn, examples of market failure. They spoil the view, yet don't really have to pay anyone compensation. They can offer inferior products because, on a hot day, the tourist can't be bothered to stray too far from the main sites in search of a cold drink or a slice of pizza. And some of them – notably the tat-selling street-hawkers who are a feature common to many of the world's major tourist attractions – are simply a downright nuisance.

So why do these hangers-on still exist? The answer, of course, is that it's terribly difficult to regulate markets successfully. Pope Pius VII, God's representative on earth, certainly failed in his mission. Directly below the plaque commemorating his attempt at an urban clean-up, there's now a branch of McDonald's.

I mention all this because the world's politicians and policymakers – most of whom, I assume, do not have a direct link to the Almighty – are having to come to grips with market failures. The credit crunch is, in itself, a market failure. The earlier lending boom was a market failure. And the likely effects – collapsing housing markets, imploding banks and rising unemployment – can also be regarded as market failures.

The key difficulty lies in knowing precisely how to react to these failures. In the case of Pope Pius VII, moral suasion clearly had little lasting effect. Despite his holy exhortations, the Piazza della Rotondo is still surrounded by the ignoble. Our latest crop of policymakers has merely followed in the Papal footsteps. For much of this decade, central bankers and assorted international agencies warned of the dangers associated with excessive lending. Despite their warnings, however, excessive lending continued unabated, driving house prices and household debt in some countries up to extraordinary levels. Moral suasion, on its own, is typically not good public policy.

For some, the financial equivalents of the sellers of cheap tat in the Piazza are the banks, who sold bundles of poor quality loans to unsuspecting investors. This is certainly a key part of the story. In the old days, banks could lend only to the degree that their deposits allowed them to do so. In modern financial systems, however, bank lending is no longer constrained by deposit growth. Banks can, instead, raise funds through securitisation, whereby they package loans up into bundles and sell them on to other investors. In this model, the limit on bank lending is not provided by deposits but, instead, by the willingness of others to invest in asset-backed securities and their various derivatives.

Until last summer, this was a very profitable business, helping to explain the increasingly lax lending standards which came to characterise the housing markets in the US and the UK. To guard against over-exuberance in this area, policymakers are now suggesting that banks should be required to hold higher reserves and that, meanwhile, there should be a very careful review of employee compensation (the upside for traders can be huge but the downside may be rather limited, thereby encouraging excessive speculation).

This approach, however, assumes that the banks are staffed only with vultures all-too-happy to pick over the carcass of a failed economy. The banks themselves, though, are at the epicentre of this latest financial earthquake and are not enjoying the experience one bit so it's not entirely clear that the institutions themselves are the only ones to blame.

The complication with the banks is, of course, that they make profits for their shareholders but equally provide benefits for society as a whole (it's difficult for any economy to function without a credit system). Thus, when they fail, there's typically a need to bail them out. It would surely have been wrong, for example, to allow the customers of Northern Rock to have lost their deposits through no fault of their own. Bail-outs, though, can protect precisely those people who took stupid risks in the first place, thereby encouraging even more risk-taking in the fut-ure. To deal with this moral hazard problem, regulators may insist that banks have to hold more funds in their reserves.

What, though, does this mean? The Basel II guidance, which provides the latest regulatory thinking, states that "a significant innovation of the revised Framework is the greater use of assessments of risk provided by banks' internal systems as inputs to capital calculations". That's all very well, but is hardly a cure for the kinds of market failures we've been seeing recently. Banks, after all, are being brought down by the actions of others. In these cases, counterparty risk (or, put another way, a loss of trust), not the size of reserves, is the issue at hand. Moreover, risk assessments themselves are prone to error. Financial innovation is generally a good thing, but makes risk a lot more difficult to gauge, as the ratings agencies now know at a significant cost to their reputations. Too often, regulators confuse risk with liquidity.

Underneath all these issues, though, is what I've for a long time called the "hunt for yield". As life expectancy has risen, the gap between official retirement age and a meeting with the Grim Reaper has gradually got larger. All of us have to think harder about how, precisely, we're going to fund our ever-lengthening dot-age. At the same time, though, many of us seemed to be hooked on credit, wanting to consume more and more today. These competing pressures can only be reconciled if the assets we invest in offer ever-higher returns. And thus we've been living in an age where each new financial innovation is greeted with the enthusiasm once reserved for the alchemist.

New regulations have to deal directly with this issue. It's all very well offering moral suasion or controlling the activities of banks but unless something is also done about the hunt for yield, unscrupulous salesmen will continue to flourish in the ever-more-complicated world of financial innovation.

Regulators and policymakers need to understand this basic truth. That means better financial education for the masses and, whether we like it or not, a progressive increase in the age of retirement. If regulators and policymakers fail to deliver in these areas, we'll simply end up with more bubbles, more false hopes and, ultimately, more impoverishment. Pope Pius presumably ended up in heaven. For those who've been hunting for yield, it's more likely to be an old age in financial purgatory.

Stephen King is managing director of economics at HSBC stephen.king@hsbcib.com