“Always bet against the end of the world.”

I once discussed the Cuban missile crisis with a senior director of the City firm where I worked. He told me he had made pocket money at school by taking bets on whether a nuclear war would break out. His schoolmates were convinced destruction was imminent as Kennedy and Krushchev faced off but he was happy to take all bets. “Always bet against the end of the world” he told me. “If you lose, you won’t be there to pay and no one will be left to claim their winnings.”

Betting against the end of the world is the nearest thing to a free lunch. It’s what people do when they take large positions against a weak stock or currency, say. It is more or less what the mortgage bankers did. It’s not that they were all too stupid to see the systemic risk, although some may have been. They probably underestimated it, yes, but they understood that if the whole structure collapsed it would be the end of their world. Who would the winners be? And where would they collect their winnings?

That’s the frightening thing about the credit crunch. It was not just caused by pride, stupidity or irrational greed. Those things contributed, but the frightening thing is that the actions of the players involved were perfectly rational, provided the system did not collapse. But whose job was it to look after the system? Actually, not the bankers’. It’s hard to see why so many of them are justified in keeping knighthoods for services to the financial sector or services to banking which were clearly based on utterly mistaken assessments. Why hasn’t this been a focus of public anger? But still, it wasn’t their job to save the system. They bet against the end of the world, which is normally a clever move. They just lost.

Whose job is it to look after the system? People who work with markets tend to believe that the market knows best. They believe it mainly because they know how hard it is to beat the market. The market tells you the price, not the other way round. So when the market tells you that the price for a lot more risk is only an extra fifty basis points, say, that’s the price, take it or leave it. If it’s your job to trade such risk you may have no choice but to take it, whatever your misgivings. But markets are made by no more than the sum of everyone’s actions. If everyone is mistaken, or forced to go along by the pressures of their job, the market will mislead. Time and time again markets lead people astray because they provide prices based on other people’s mistakes.

For example, in the late seventies and into the eighties banks made loans to developing countries at tiny margins over the banks’ borrowing costs, because that is what the market said was the right price. You could choose not to be in that market, but you could not choose to participate at a different price. And the fact is that people made a lot of money as they went along from arrangement fees and syndication fees and suchlike, so it was a brave banker who was prepared to explain to the board why their bank was on the sidelines.

In the eighties shares in Japanese companies went up in price beyond everyone’s idea of what a share should cost, but kept on going. Japan was a large part of the world market in shares and no portfolio could hope to perform well if it did not invest in Japan. Many professional investors tried to stand aside, but “the market” proved them wrong by just going on up. It might not have mattered for one year, say, but the Japanese market outlasted the patience of trustees and asset owners by going up year after year, so that professionals got fired for not investing in Japan. People invented all kinds of reasons why shares were not overvalued until of course the market crashed, providing a foretaste of 2008.

We have financial regulators, but they mainly regulate companies not markets. In any case, they will always be confounded by banks who promise success provided the system works as it is. Regulators are unlikely even to spot a bet against the end of the world, such bets are apt to seem sensible if you are the one looking after the world. But markets don’t always work and it really matters when they don’t. That is why we need a different kind of market oversight. There is no invisible hand, just a lot of people making among them many small mistakes, which sometimes cancel out but sometimes add up to a big mistake. Of course there is an important role for detecting and deterring dishonesty. But someone has to stand back and look at the system as a whole. The question is, can anyone do the job? Too heavy a hand and enterprise and innovation are stifled: too light and the system crashes. Any regulator stands outside the pressures of the market, which is why he/she will always be secretly despised by participants anyway. But looking after the system means sometimes stopping the party when it is in full swing, before the partygoers get so drunk they fall out of the windows.

No politician would dare do it and every politician would be lobbied hard to tell such a regulator to back off when it really mattered. Can a democracy then provide effective financial oversight, moderating the risk in the system as a whole? It’s a difficult question, because the overseer would have huge responsibility and require enormous powers. Perhaps we should have an official whistleblower, preferably not a government appointee, preferably without executive responsibility and therefore without an incentive to report that they have everything in hand. This inspector would report regularly and require governments to give a full public account of why they accepted or rejected the advice. That way, power and accountability would remain where they should be, with the elected government. Would this help? Alas, maybe not, for perhaps the unlucky incumbent would either be lulled by decades of apparent success into not noticing danger ("Not My Fault" Gordon springs to mind), or ignored as a Cassandra. We may have to accept that markets will continue to boom and bust. If so, economies will follow them, whatever anyone says.