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More on financial crisis, market failures and government failures

Shanta Devarajan's picture

My earlier post on the lessons to be drawn (and not drawn) from the financial crisis for the balance between state and market in developing countries elicited a lively discussion on this blog. Many of the comments responded to other comments, which gladdens the blogger’s heart (and eases his workload). More seriously, I recently came across two papers that significantly deepened the points I was making in that original post. On the first point, that any financial system requires some form of regulation, Asli Demirguc-Kunt, Jerry Caprio and Ed Kane have written a valuable piece that looks for lessons rather than scapegoats from the current crisis. Their punch-line is “that the principal source of financial instability lies in contradictory political and bureaucratic incentives that undermine the effectiveness of financial regulation and supervision in every country in the world.” Such incentive problems are precisely the reason why we need regulation.

On the second point I made, that the failure of wrongly-regulated financial markets should not be used as justification for greater government intervention in all markets, David Lewis gave a brilliant keynote address at a recent conference in South Africa entitled ”Competition Law and Policy in Bad Times,” where he cautioned against using the current financial crisis to revert to state-led, rather than market-led solutions to economic growth: While intervention is going to be necessary and inevitable, it may, as before, store up considerable problems for future growth and prosperity.