"If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary.
In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. "
James Madison, Federalist No. 51
Here in the UK, we could learn much from the discussions that followed American Independence. When creating that great republic, the founding fathers wrestled with two questions. First, how do you create institutions that are robust enough to deal with the ingrained venality of people. Second, how do you ensure that those institutions, controlled by venal individuals, behave themselves.
Here in the UK, how did we fare when it came to the government of our financial institutions? It is not an industry that normally attracts angels. Therefore, there was a need to limit the more destructive activities of bankers.
For at least a century, we had a very competent financial supervisor; the Bank of England. When confronted with anything dubious, the governor would raise an eyebrow a few millimetres, and everyone got the message. While the Bank was in charge the city, there wasn't a single run on a high street bank. When some of the more exotic banks ran into trouble,the BoE effectively and discreetly sorted them out.
In the name of change, New Labour threw into the dustbin all that accumulated regulatory experience. In its place, it established a naive and untested regulator - the FSA. Ten years later, it has proved to be one of the most disastrous decisions during the post war period.
The new agency could not properly control or monitor the banks and their various off-balance sheet shadow activities. The FSA watched helplessly as credit exploded, the housing bubble took off, and bank staff created new value-reducing financial products.
From a very early stage, it must have been obvious to the government that something was terribly wrong at the FSA. The chacellor only needed to look into an estate agent window and see that the financial system was cooking up an almighty crash. Why didn't the government do something to sort out the obvious regulatory failures at the FSA?
New Labour had no interest in controlling the credit boom and didn't want the FSA to crack down on the banks. In the absence of angels, highly unstable industries like finance needs proper government. However, regulation alone is not enough. Politicians needed to ensure that the regulators actually regulated the financial sector.
Here, we come to the deep insight of James Madison. New Labour was unable to "control itself". For ten years, the housing bubble worked for Brown and Blair. Expanding debt levels kept household consumption growing, while wages were stagnating and key sectors of the economy like manufacturing hit one recession after another. The bubble allowed New Labour to spin the myth that the UK economy was thriving when it was in reality drowning in debt. Now that myth is exploding, leaving a terrible financial crisis in its place.