Some modest proposals to make the financial system even stronger

This said, it would be helpful to include courses on the essence of modern finance in school programs, courses that teach people to beware of conmen and that if something looks too good to be true it probably is. Naturally, proven fraud must be punished, and that is a feature of regulatory systems that need constant attention. But as Charles MacKay said in his wonderful book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds: 'Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people - the degrading lust of gain, which had swallowed up every nobler quality of the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors'.

Rules for prudential management of banks should require them to hold sufficient capital to provide real discouragement to practices that too easily allow, indeed encourage, funding of asset booms. Some form of dynamic capital ratio regime is desirable, with required reserves as a ratio to assets rising as a boom gathers strength. The aim should be not to stop an asset boom, but to make sure it has been properly tested and is not being engorged by a diet of easy money.

I am happy to stand with Paul Volcker - the world's greatest central banker - in calling for the return of the Glass-Steagall law in the United States, and equivalent rules elsewhere. Such laws separate financial institutions into 'commercial banks' which are closely regulated may have government-backed deposit insurance and 'investment banks' that are lightly regulated but with no government guarantees. It is also desirable to use anti-monopoly laws to attack the problem of institutions that are seen to be 'too big to fail', though with global financial institutions this probably requires at least international coordination through one or other of the relevant international financial organisations. Clearly, regular stress-testing of bank balance sheets is highly desirable and one expects this to be done with global outcomes in mind.

It is far harder to anticipate and to provide similar resistance to new forms of finance. But, as we have seen, new forms of finance, including the now infamous securitised sub-prime loans, are part of the landscape of boom and bust. The trick is to find ways of preventing the generals of financial regulation from fighting the last war but one. Listening with respect to outsiders is one technique that might be suggested to senior regulators, perhaps reminding them that it is the grain of sand that produces the pearl. Firing or requiring the resignation of a regulator who has failed is of course applying a classic capitalist technique to encourage the others and should probably be used more often than it has been.

This writer believes that, in a sufficiently serious crisis, it is desirable for large financial institutions that are at risk of failing to be rescued by relevant governments. This is a controversial matter. The standard objection to bailout is that it encourages what economists call 'moral hazard'. If financiers develop foolish management practices leading to failure, but are rescued, they (or their successors) have little incentive to behave more sensibly in future. Extreme free market economists say allowing failed financial enterprises to go broke will remove this moral hazard and make for a more robust, sustainable financial system. The trouble is, if failed financial enterprises are big enough to create a serious, potentially global, depression, avoidance of this will dominate thinking in any real crisis.

President George Bush said while announcing his bailout plan during the Global Financial Crisis: 'I'm a strong believer in free enterprise, so my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course. But these are not normal circumstances. The market is not functioning properly. There has been a widespread loss of confidence, and major sectors of America's financial system are at risk of shutting down.

'The government's top economic experts warn that, without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold'. This could be put more simply. I recall seeing President Bush saying on global television something like 'I didn't want to do this, but they told me there would be a great depression if I didn't'.

The trouble with not providing bailout has been seen many times before. To take just two examples, the inability of the Victorian colonial government to bail out the financiers in Melbourne in the 1890s meant many sound banks as well as unsound financial institutions were forced to shut their doors, making the downturn far worse than it might have been. The US government's inability or unwillingness to save the myriad of US banks was also a material factor in making the Great Depression of the 1930s far worse than it might have been, as current US Fed Chief Ben Bernanke's own research shows.

In the Global Financial Crisis of 2007-08, the risks of declining to bail out a major financier were seen in the case of Lehman Brothers. This unlovely organisation no doubt deserved to fail, but its failure produced a situation of massive financial gridlock that caused the world of finance to wobble on its axis, and could well have turned a nasty downturn into another Great Depression. There is still risk of such an outcome, focussed on the twin issues of global inflation and sovereign debt default, so we need to be crystal clear that bailout is necessary – with provisos.

Government bailing out companies 'too big to fail' should take equity in the failed enterprise so that taxpayers have a chance of recovering their investment. The rules should also provide for the dismissal with minimum or no compensation for the most senior executives and board members as soon as replacements are installed. This requires that unequivocal failure – defined as requiring taxpayers' funding – is like proven fraud as a case for dismissal without the usual protections of contract law. These two rules should help to overcome the so-called 'moral hazard' implicit in bailout with no real sanctions.

Governments also have an interest in the design of incentive plans for executives in major financial institutions. How this should be implemented and enforced is worthy of debate, but I am confident that rules are desirable that encourage executives to take a long-term view of the profitability and viability of the financial institutions that they manage. Similar rules may benefit other corporations also but the mooted change is vitally important for the health of a nation's financial system. Indeed, in the cases of major global banks and other financial institutions, it is vital for the health of the global economy.

Principles that are highly desirable include the following: bonuses go into a trust that is not paid out until some time, eg five years, after the executive retires; clawback allowed (indeed required) on some pro rata basis if losses are made, so that executives cannot benefit from taking large risks and being rewarded only for success, with no penalty for failure; bonuses earned in this way might be taxed when received at the normal capital gains rate.

In the absence of sensible changes to the regulation of global finance, the world faces a repeat of the extreme financial boom and bust that led to the Global financial crisis of 2007-08. There is evidence that boom and busts have been getting both more frequent and larger. The risk is that a future boom and bust will lead to a global downturn that becomes a great depression.

Vote for serious economic and financial sector reform, gentle readers. You will be doing your children and grandchildren a great favour.