Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Will today’s ever widening global financial crisis mark the end of the era of financial triumphalism? Ask a lay person to list the ten great innovations that drive our world today and you probably won’t find too many who mention the Black-Scholes formula for pricing options. But for the financial community, pioneering formulas that paved the way for modern hedging strategies should get just as much credit for the passing period of rapid global growth as cell phones, computers, and the Internet.

Until the last 12 months, finance advocates seemed to have a strong case. By helping to spread risk, high-tech finance could help economies grow faster. Macroeconomists celebrated the “Great Moderation” of the global business cycle, with recessions seeming to become milder and less frequent. And, of course, the financial community was making money hand over fist, creating scores of millionaires and even billionaires worldwide.

Governments were cheerleaders, too. In anglophone countries, presidents and prime ministers, not to mention some leading central bankers, boasted of superior financial systems that were the envy of the world. When French and German leaders complained that the sprawling and unregulated tentacles of new finance posed huge risks to the global economy, they were derided as sore losers. Small countries such as Iceland decided to get in on the action by privatizing their banks and setting up their own financial centers. If you cannot be Silicon Valley, then why not create a mini-Wall Street?

Now Iceland’s banks, having borrowed several times the national GDP, are in desperate trouble, with debts far beyond what the small country’s taxpayers can absorb. Even the conservative Swiss gave into the temptations of high-tech finance and the riches it promised. Today, the two largest Swiss banks are sinking in liabilities that exceed seven times the country’s income.

Of course, the mother of all bailouts is the absurd blank check the United States government is granting the giant home mortgage lending agencies Fannie Mae and Freddie Mac, which hold or guarantee $5 trillion in mortgages that are looking increasingly dubious. It is ironic indeed that US Treasury Secretary Hank Paulson, a former head of Goldman Sachs, a firm that exemplifies financial triumphalism, is spearheading the effort to save government-sponsored behemoths that have so conspicuously outlived their usefulness.

Advances in the field of finance have potentially had a beneficial impact in raising and smoothing global growth. But there is also a cyclical element to the flowering of finance. When home prices were soaring, the geniuses behind mortgage finance seemed infallible. Now that prices are falling, the genius strategies don’t seem quite so brilliant.

It is an old story. Back in the early 1980’s, financial engineers invented “portfolio insurance,” a fancy active hedging strategy for controlling downside risk. They made piles of money. Unfortunately, when global stock markets crashed in October 1987, the insurance turned out to be useless, mainly because markets for hedging collapsed.

In the late 1990’s, the US hedge fund Long-Term Capital Management convinced the world that its partners were masters of the universe. For a while, it consistently made outsized profits, supposedly due to its Nobel-prize backed financial expertise. In 1998, when LTCM went bust, it became all too clear that the firm was basically making massive quantities of simple bond trades, with huge leverage and huge risk.

For governments, the key to success in regulating financial markets lies in maintaining reasonable constraints during boom times that prevent taxpayer funds from being put excessively at risk. Unfortunately, this is difficult to do, because boom times make people who warn of risks seems like doom mongers. That is why it is so important that governments allow financial firms to fail occasionally. That is the only way to impose real discipline on shareholders, bondholders, and corporate leaders.

Is the current gilded era of financial triumphalism over? There is talk in many countries, even the US, that the time has come to ensure that the entire financial system, including hedge funds and investment banks, become subject to much stricter regulation.

Financial firms are screaming murder, but it is not obvious that broader and better financial regulation would be a bad thing. In my research on the history of international financial crisis with Professor Carmen Reinhart, we find that eras of heavy financial regulation tend to have significantly fewer financial crises than lightly regulated free-wheeling eras, such as those associated with the recent period of financial triumphalism.

No one is suggesting that we go back to the “financial repression” of the 1950’s, but the latest crisis has left little doubt that the entire system for global financial regulation is in serious need of an update. Financial innovation ought to be allowed to flourish, but not without better checks and balances. Otherwise, we will be forever trapped in a framework where taxpayers are forced to bail out banks in bad times, while wealthy shareholders reap huge profits in good times. It is time to leaven financial triumphalism with some humility and common sense.

Source: Project-Syndicate August 2008