TODAY’S FINANCIAL markets will inevitably suffer another crash. It might come soon, especially if recent inflation proves to have more staying power than the authorities suggest. But even if markets escape trouble in the immediate future, wild swings are an unavoidable feature of financial markets. Nor can any reasonable regulation guard against them, certainly not those Washington put in place after the last crisis. Regulation is simply inadequate to the task.

The only taming mechanism that might work would so tighten regulatory control that the United States would lose much of the contribution finance makes to the nation’s prosperity and economic development, a cure worse than the disease. Since governors from the past—gold and fiscal discipline, for instance—have little practical application today, a best solution, perhaps the only one, would keep regulations as a moderator but admit that the goal of control lies beyond our reach, that severe risks remain present always. Perhaps such a sense might instill in financial management more prudence than it has shown in some time, enough at least to ameliorate boom-bust tendencies. Such a sense and the caution it instills among financial players have done so at times in the past.

THE REGULATORY approach did little to prevent the crash in 2008–09. Dodd-Frank regulation did not exist at the time, but several authorities—the Federal Reserve (the Fed), the Comptroller of the Currency, and state regulatory bodies in this country; the Bank for International Settlements (BIS) in Basel, Switzerland, internationally, and equivalents in most other countries—imposed regulations to guard against financial excess and collapse. Yet all their rules failed to stop the preceding boom and that terrifying collapse. When the investment bank and broker-dealer Bear Stearns revealed problems and began the crisis early in 2008, the firm was in full compliance with all regulations. It was fully solvent by all the most up-to-date accounting standards. Nonetheless, it was unable to meet all its immediate trading obligations. Almost as an admission that the regulations were inadequate, the authorities tried to control events by immediately reaching outside regulatory structures. They forced Bear Stearns to sell itself at a bargain price to J.P. Morgan—a preemptory move that may in retrospect have created more uneasiness among investors than it alleviated.

Even though all major financial institutions had adhered to existing regulations, the financial crisis got worse before it got better. At each stage in the collapse, the authorities met the challenge of the moment by moving outside their own regulatory structures. Ultimately, the Treasury Department put billions of taxpayer dollars at risk, lending to financial institutions through what it called the Troubled Asset Relief Program. The Fed and other central banks brought lending rates around the world down to inordinately low levels, near zero in fact, and found novel ways to make billions in financial liquidity available to otherwise failing banks and other financial institutions. The authorities forced sales, made extraordinary loans, took over financial firms, and let others go bankrupt in the process. If this jerry-rigged approach did not exacerbate the panic, it certainly confirmed the feeling at the time that no one had control. More than anything else, the extraordinary measures pointed up the inadequacy of the regulations.

Following the crisis, Washington set out to put safeguards in place largely by doubling down on the regulatory approach that had just failed. Though the details of their new rules are even more complex than the old, they mostly just strengthen what had previously existed. The BIS’ latest set of guidelines, for example, under the heading Basel IV to distinguish them from the old Basel II and III rules, deals with the problem by stipulating that banks should set aside a total of some 8 percent in capital of various kinds, depending on the risk of their asset mix. This emergency capital is typically held in very safe repositories, government debt or deposits at the central bank, where the financial institution can draw on it quickly and reliably to meet obligations when the normal course of business fails to do so. The Dodd-Frank financial reform in the United States essentially has done the same. It includes two additional noteworthy measures. It singles out larger institutions where failure might threaten the financial system, designates them “too big to fail,” and imposes on them especially stringent capital requirements. It also stipulates that these institutions undergo periodic “stress tests” to see how much financial trouble they could withstand.

These new, more stringent, and intrusive rules may provide some safeguards. They may help the regulators—and the public—feel more secure. They may even give comfort to people involved in finance. At bottom, however, they, like the old rules, are chimerical. At least three reasons stand out: 1) because rules, by nature, focus on particular institutions, financial vehicles, and processes, they cannot cope with finance’s protean ability to create new institutions and new processes that effectively sidestep the regulations; 2) regulations do little to counteract the tendency for finance to build on success and so inexorably move in good times toward extremes that ultimately create problems; and 3) the capital ratios and stress tests imposed on financial institutions do little to alleviate the inherent risks banks and other financial institutions must take in the normal course of their business, risks that can easily swamp even the most severe capital requirements demanded by regulators. The following three sections take up each of these regulatory inadequacies in turn.

THE FIRST of these problems lies with the unavoidably legalistic nature of regulation. Rules must state explicitly to which sorts of institutions they apply and under which conditions. While such constraints may limit risk in the sorts of institutions and activities they identify, the constraints themselves only invite the development of new institutions, practices, and arrangements not explicitly covered by the rules. Dodd-Frank, for example, constrains how much risk banks can take and what provisions for loss they must make at each level of lending risk. But because risky borrowers still want funds and will pay relatively high rates to get them, new institutions and practices have arisen to fill the gap left by the constrained banks. A so-called “shadow banking system” has taken considerable business from conventional banks, especially smaller regional banks, since Dodd-Frank went into effect. It has effectively taken on the risks banks once took. Despite the tightened regulations, the financial system as a whole remains exposed to those risks and remains as vulnerable as it was. All that has happened is that the epicenter of risk has moved.

Similarly, the regulations put in place after the 2008–09 crisis primarily focus on real estate. The system’s vulnerability at the time centered on failing mortgages. The banks are loath to extend themselves into this area because the regulations stipulate so many constraints and because the bankers are well aware that the regulators are watching. Until recently, they exercised greater prudence in real estate lending than even the rules require. But they also want to provide attractive returns to their stockholders. They have, accordingly, lent more actively than before to risky corporate borrowers that will eagerly pay higher rates to get the funds. Depending on how one measures them, these so-called leverage loans have grown some 7–10 percent a year since the Dodd-Frank regulations came into effect. Today, they verge on $3.5 trillion outstanding. Because leveraged loans were not the cause of past trouble, they are of a lesser importance to regulators and are not as covered in written regulations. Again, risks have simply shifted, not disappeared.

No doubt some would suggest that the system would find better protection if the regulators had the freedom to adjust which institutions and practices the rules cover and impose similar strictures on any new, potentially threatening practices or financial instruments. If such an approach might offer comfort about future crises, it would impose other difficulties. It would, in fact, shift decisions on the allocation of the economy’s financial resources from financial decisionmakers and markets to regulators. Because regulations by design have a one-sided focus on risk reduction, such a “solution” would limit the financial resources available to build new businesses and expand established ones. After all, some of the most productive developments throughout time have looked very risky at their inception. Society would accordingly suffer slower rates of growth and job creation. Such regulatory discretion would not quite count as the sort of central planning that failed in the Soviet Union. It would actually be worse, since risk aversion would be its only consideration.

NOR CAN regulations effectively stop the tendency for the financial system to go to extremes. This problem develops because past lending successes, presumably in good economic times, increase the flows of profits to financial firms, with which they can enlarge the capital base and, accordingly, extend more loans and investments. As that lending increases profits even further and likely also raises the value of financial assets as well, this capital base rises even higher, encouraging further lending. The system effectively builds on itself. Indeed, the rising base all but impels financial managers to lend more and more, and so take on more risk. If prudence holds them back, they seem to waste opportunities for profits and put their positions at risk. In the words of the ex-CEO of Citigroup, Charles Prince, “as long as the music is playing, you have to get up and dance.”

A particularly pointed historic reference can illustrate how the process develops. In the early nineteenth century, land banks were common in rural America. These institutions grew up around the acquisition and transfer of frontier land. The founders of such institutions would buy a parcel of land and use its value as the initial business capital to get a banking charter, take deposits, and lend out money, primarily for others to purchase land. The more these banks lent, the greater the demand for land and the higher the market value of their original land-based capital. These banks then used the increased value of that base to lend more. The up cycle continued until land prices lost all touch with reality. As fewer and fewer people could afford to buy, despite the easy credit offered by the land banks, reality reasserted itself. Land prices began to fall, and the process worked in reverse, frequently at lightning speed. The banks failed.

Something like this happened in the years leading up to the 2008–09 crisis. No bank used land as basic capital; the regulators never would have permitted that. But these banks were able to package their dubious mortgage lending into bonds that they then sold to the public. The cash they then received allowed them to enhance the value of their capital base, one recognized by the regulators. This enabled them to expand their mortgage lending anew, in other words, leverage their past gains. Because the flow of lending helped bid up real estate prices, the value of banks’ real estate assets also rose, encouraging them to lend still more. The process bid real estate prices still higher. The capital seemed adequate for the banks themselves, but since the banks sold off so much of the risky debt, the whole system piled enormous amounts of risky real estate credit onto an only slightly enlarged capital base. For a while, real estate prices kept rising, but the further they rose above people’s fundamental incomes, the less affordable real estate became. Eventually, buyers disappeared, prices began to fall, and things worked in reverse, just as with the land banks.

Critics point to the pattern as an illustration of the spectacular greed of finance. Yet, without doubting for a moment the greed of Wall Street, the pattern would have persisted even if those involved were saints. Finance cannot help but build on itself in this way. Any manager who balked at the process would have lost his or her job. Presumably, regulators could have slowed the process had they, for instance, insisted on capital to back each bundle of loans the banks sold to the public. But the hitherto described institutionally-based nature of the regulation prevented such a move, even had regulators considered it, which the evidence suggests they did not. The accounting and administrative difficulties of such an effort probably would have proved insurmountable in any case. Besides, the authorities at the time wanted to encourage homeownership for political reasons, even to those with dubious abilities to service their debts, and so had little inclination to stop the process, whatever they claim now in retrospect.

AT THE most fundamental level lies the third reason regulation fails. Huge risk simply is implicit in finance. The great complexities of modern finance can obscure this underlying nature, but it is nonetheless unavoidable. To see why, consider the two basic functions banks and finance generally have in the economy: 1) they offer depository services to businesses and individuals in support of essential day-to-day payments, and 2) they bear the cost of that function and turn a profit, they lend out a large portion of those deposits at interest to individuals and businesses and in this way promote economic expansion and development.

The process creates prosperity, but a simple illustration can demonstrate how much risk is involved. Say, for example, administration and interest paid on deposits cost banks a mere 1 percent of the total amount involved. If they lend all the money out at interest and charge the borrowers, say 4 percent, they would enjoy a margin of three percentage points over cost. If any more than 3 percent of their borrowers failed to pay, they would struggle to meet obligations to their depositors. A capital set aside of 3 percent would just cover it. The Basel requirement of 8 percent would protect them. But even a minor recession could easily create more troubled loans than 8 percent, and a major recession could drive up the problem loans to well over 10–20 percent. The banks are always at risk of collapse.

Of course, modern finance is much more complex and sophisticated than this. Banks have loan loss provisions on top of the capital demanded by custom and regulations. Deposit flows also make the calculations more complex than portrayed here. Loan covenants can protect the flows of repayments even if borrowers go bankrupt. Other institutions have different practices. Investment banks help larger firms borrow by selling their bond issues to other investors. Private equity and venture capital firms use their own funds to support new ventures and also enhance their ability to extend more to business by themselves borrowing from banks and elsewhere in the financial system. Complex practices and even more complex financial instruments support these structures. But fundamentally, all behave much like the above, admittedly simplistic, picture of the banks. The nature of all this business creates existential risks for them, even if only a relatively small portion of their borrowers fail.

Some might want to erase this risk by insisting on regulations that would, for instance, demand capital set aside of 25 percent or more. That would guard against failures to be sure. But it would also block a significant part of the economy’s financial resources from flowing to the businesses and people who need it to expand, innovate, and hire more workers. It would also make it all but impossible for the banks to operate the economy’s payments system. If, for instance, only 75 percent of the deposits of the earlier example were lent out at 4 percent, the average inflow, if everyone paid, would amount to only 3 percent of their deposit amount, giving banks only a two-percentage-point margin over the cost of supporting the deposit and payment system. The huge capital requirements would relieve the risk in the financial system, but the small return to banking would raise questions about whether the operations are viable. If such circumstances caused the banks to close their doors, the economy would lose both its payments system and the financial flows needed to support economic expansion. It is in consideration of this tradeoff between risk on the one hand and support for the economy on the other that prompts the BIS and other regulators to accept risk and do their best to keep the required capital cushion relatively small.

IF, THEN, regulatory approaches have clear limitations, a natural response is to look to other means that might instill prudence into financial decisionmaking. On this score, history offers a guide, but only a tenuous one. Once, an insistence on a gold base blunted these otherwise dangerous financial tendencies. Even in the absence of regulatory authorities, market practice once dictated that banks resist the tendency to build too much lending on their gold holdings. Without assurance that regulators would relieve risks, depositors and investors during these times avoided institutions that went too far beyond their gold hoard. To get depositors, banks bragged on the adequacy of their gold base. Custom dictated a percentage not much different than the capital ratios demanded today by the BIS, Dodd-Frank, and other regulatory bodies. These arrangements did not stop financial panics. The land banks, of course, operated outside gold’s influence. And even in areas where financial institutions held gold capital, the dangers of finance described above created problems from time to time. But an element of prudence existed that is missing today.

Gold offered the system two other virtues that helped secure it against collapse. One, it was widely acknowledged as having intrinsic value. The concept of intrinsic value is, of course, suspect. Value is only what markets think it is. Still, the illusion of unquestioned value gave borrowers and lenders a calming confidence that could quell a panic before it began. A second virtue was the constancy of gold’s price. The value of the gold did not rise and fall with the activity of banks. On the contrary, it was more or less fixed at a figure all prospective depositors and investors could see and on which they believed they could rely. If banks remained vulnerable to even a small loss from lending, and they were, the fixed value of gold blunted the tendency for gold-based banks to build on past success as the land banks did, and the modern system does and did in the run-up to the 2008–09 crisis.

Sadly, a return to gold would fail to meet modern needs, regardless of what the gold bugs say. The stock of gold is too small to form a base for today’s immense financial system. If banking and finance tried to return to it, the metal’s price would rise to astronomical levels. Besides, gold holdings are too unevenly distributed around the world to support the modern, global system. What could apply is the gold substitute that Alexander Hamilton devised to support America’s finances in the 1790s.

Back then, the rest of world finance ran on gold, yet the newly formed United States had too little of it for its needs. All the gold available in this country flowed overseas to pay interest and principal on the huge debts incurred during the war for independence. Without an acceptable base, the nation lacked a financial system. Additionally, it had no money of its own—Americans depended on a mélange of foreign currencies and paper privately-issued by presumably trustworthy merchants. Without a domestic deposit base, the country also lacked an effective means to advance credit. Business could not even finance the purchase of inventories, much less procure longer-term lending to support expansion and innovation. Hamilton devised an imaginative substitute for gold that, at least theoretically, could work today.

Instead of a gold base, he offered the debt obligations of the federal government. At first, this might seem counterintuitive, but he nonetheless so arranged the governments affairs that the debt served the purpose. He put the government’s finances in order and made it clear that the debt would always pay in full and on time. He reinforced this promise by establishing a sinking fund to earmark a portion of the government’s annual revenues for debt repayment. That secured the first virtue of gold, the confidence people had in its value. To make the government obligations still more like gold, he endeavored to fix their price. He used the sinking fund to act in markets to that end. He also established the First Bank of the United States—a government-private partnership that would effectively serve as the government’s bank, set an example by conducting itself on prudent principles, and also stabilize the price of government debt by buying and selling the bonds in the market. The solution worked. The public looked on the debt as good as gold. And since the guarantees of payment rested on government revenues, they were effectively tied directly to the U.S. economy’s ability to produce. In this way, the debt was actually more realistic than gold.

In some respects, today’s financial system would seem open to a Hamiltonian solution. It is, in many ways, as Hamilton established it some 230 years ago. Though from time to time the United States declared itself to function on a gold base, the financial system has always rested on a base of government obligations. Unfortunately, a return to these arrangements would demand an unlikely move in Washington to tether debt to revenues and, consequently, to the real economy, as Hamilton’s scheme did. At the very least, Washington would have to put debt on a predictable path. In today’s political milieu, such a move seems far less than likely. Policymakers would also have to assure the public that they would tether the liquidity in the financial system to revenue-linked debt, or at the very least put it on a predictable path. Such assurances are antithetical not just to current fiscal practices but also to the nation’s monetary policies, which create liquidity with little reference to government finances.

IF SUCH a return is impossible and regulation, though helpful, remains inadequate, it would seem that boom-bust patterns are inevitable. They are. Ironically, however, recognition of the risks involved, and the inadequacies of regulation could itself help moderate if not actually tame the boom-bust character that so frightens so many people. If the authorities were to admit freely that their ability to control matters is limited and that the system carries inherent dangers, financial people, businesses, and individuals might proceed with greater caution than heretofore and insist that others do the same. Depositors might prefer institutions that have demonstrated more caution. Financial managers might enhance their career prospects instead of injuring them by showing sensitivity to excess. They might have a better chance to explain to boards and shareholders why they want to avoid “the dance,” in Charles Prince’s words.

As long as there is a pretense that regulation can do the job, these decisionmakers have little incentive to embrace prudence or even consider it. One could say that the inflated claims of regulations and regulators have introduced a moral hazard by allowing people to believe that they can neglect reasonable caution. An expectation that this acknowledgement of reality would induce a moderating prudence is admittedly a slender reed on which to base optimism, but it is all the country possesses.

Milton Ezrati is a contributing editor at the National Interest, an affiliate of the Center for the Study of Human Capital at the University at Buffalo (SUNY), and chief economist for Vested, the New York based communications firm. His latest book is Thirty Tomorrows: The Next Three Decades of Globalization, Demographics, and How We Will Live.

Image: Reuters.