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Building a Playpen for Derivatives
Posted by Kate O'Sullivan | | US
May 19, 2010 4:32 PM ET

At the CFA Institute's annual conference in Boston on Wednesday, Nobel Prize-winning economist George Akerlof used a playpen analogy to make a case for regulating derivatives. When toddlers are in a playpen, parents don't need to watch them very closely, he explained. Likewise, if the use and trading of derivatives were carefully regulated, it would reduce the chance that somebody would get hurt.

CFOs may bristle at the idea of increased regulation and government intervention in the financial system, but Akerlof said that's just what the economy needs to regain its footing and keep out of future recessions. Praising the bailout of the banking system as "a true miracle," he called for regulators to be "much less passive."

"The dramatic actions taken by the government in the fall of 2008 saved us from a reenactment of the Great Depression," said Akerlof. Without the bailout, he said, the United States could be facing an unemployment rate of 25%. He also argued that the government should be engaging in deficit spending to boost employment.

Going forward, Akerlof said the financial sector needs more regulation to control for the irrationalities at work in the market -- forces he and fellow economist Robert Shiller described in their recent book, Animal Spirits. Such factors as overconfidence, corruption, illusions, and trust all played a role in the recent economic boom and bust, Akerlof maintained.

"Most investors surmise the value of assets through what other people tell them. And when they are overconfident, they trust what people are telling them and prices rise," he said. "Events like the Madoff [Ponzi] scheme and the boom in subprime mortgages were indications of people's lack of skepticism about where they parked their money."

Comments (2)

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Sir George Akerlof is 100% right. We need relulations-an active one and not passive one. Afterall we all have animal spirits which need monitoring.
Posted by Mohd Mateen | May 20, 2010 08:03am

There is alot of good sense in this commentary. But it is unrealistic to think that the regulatory framework will eliminate fraud or bad decisions. In fact, the history of the global regulatory capital framework for banks suggests that today's regulatory changes will create tomorrow's distortions. The changes being contemplated in the regulation of derivatives, trading activities, and bank structure will have a profound on the access to credit and working capital for all firms over the next 2-5 years.

Understanding the details of how the changes under discussion in the G20, the IMF and the BIS will affect corporate access to credit and capital in the US and beyond will be key to the efficient allocation of resources and, thus, economic recovery and employment. Taking into account the common sense logic behind behavioral economics is just the start of a much longer process that will re-design credit intermediation for all market participants, including corporate customers.

Posted by Barbara Matthews | June 04, 2010 02:33pm

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