Re-regulating financial markets to reduce their vulnerability to crisis is a priority of President-elect Barack Obama. But how can he achieve this and yet recognise that markets are vastly superior to state regulators in allocating scarce financial capital?

The hallmark of capitalist economies is that they provide powerful incentives for individuals to seek new ways of doing things. Asset prices fluctuate as markets assess the values of such innovative activities. But movements away from historical benchmark values sometimes become excessive, setting the stage for sharp reversals. Such reversals cause crises in the financial system that threaten the economy’s overall health.