With governments hard at work on a new financial regulatory framework, what can they do to prevent future financial black holes without blocking economic growth? New regulation and oversight of credit default swaps and other over-the-counter derivatives market is being contemplated. Unfortunately, given that regulating over-the-counter exchanges between private parties is highly complicated, firms will find ways around the regulatory fence, which might lead to future blowups and large scale bailouts.
As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many countries in the developing world have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalization and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalization by itself did not generate crises: government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not that different.