The final lesson follows from the first two: current markets are built on both private entrepreneurs and public law enforcement. For centuries, investors have relied on courts to enforce contracts. Who would buy a company’s shares if the law didn’t impose a fiduciary duty on their issuer? Every person with a bank account in the United States relies on the government to protect his or her assets. Taxpayers also trust that the government can make the costs of overseeing the banking system reasonable.

So who failed? Certainly, the shenanigans on Wall Street remind us that capitalists are not angels, and that unchecked, their mischief can do much harm. But the point of financial market regulation was to ensure that misbehavior would not imperil the entire system. Our public system failed to protect taxpayers from the costs of bailing out investors.

The failures of our regulators shouldn’t be much more surprising than the wrongdoings of investment managers. After all, governments are made up of imperfect humans also. This crisis, like most previous crises, should remind us of the frailty both of individuals and of our institutions.

What does this frailty mean for future policies? Should we be increasing the size of government, because the private sector is awful, or decreasing it, because government is incompetent? I always prefer the via media, the middle way, which in this case means doing a limited number of things more effectively.

Much of the rhetoric about crises or failures of capitalism either posits a straw man--an unfettered laissez-faire capitalism that does not exist in the United States, or for that matter anywhere else--or suggests that excessive deregulation has allowed banks to take excessive risks. It has certainly not been the policy of the U.S. government to allow financial markets to "regulate themselves," as some have claimed, although safety and soundness regulation--the supervision of the financial health of institutions--has been limited at the federal level to banks and to two government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Such regulation is logical because commercial banks are backed by the government through deposit insurance, a lender of last resort facility offered by the Federal Reserve, and a Federal Reserve payment system to which only banks have access. The GSEs, although not explicitly backed by the government, were seen in the markets as performing a government mission and, hence, as being government backed. Once any kind of financial institution is seen as being backed by the government, market discipline is severely impaired, and--to protect itself against losses--the government must impose some kind of safety and soundness regime.

Other major participants in financial markets--securities firms and insurance companies--are not backed by the government and are thus subject to a far less intrusive regulatory regime than banks are, but they nevertheless function within a complex web of regulation on business conduct and consumer protection. The condition of the banking industry today, far from offering evidence that regulation has been lacking, is actually a demonstration of the failure of regulation and its inability to prevent risk taking. Because this is not the first time that regulation has failed to prevent a major banking crisis, it makes more sense to question whether intrusive and extensive financial regulation and supervision is a sensible policy rather than to propose its extension to other areas of the financial sector.

What most critics of the current system do not seem to recognize is that the regulation of banks has been very stringent, particularly in the United States. As I will show, the commercial banks that have gotten themselves into trouble did so despite strong regulation. This is an uncomfortable fact--maybe what some would call an "inconvenient truth"--for those in the Obama administration and elsewhere who are advocating not only more regulation but also extending it to the rest of the financial system.