The invisible hand of Adam Smith

His name is Adam Smith, and his relentless market discipline is already building a safer, more conservative financial system without any new regulation at all. For weeks now, structured-investment vehicles (SIVs), dodgy asset-backed commercial paper and the like have been moving onto bank balance sheets. Hedge funds are unwinding, or at least the riskier versions are. Derivative contracts are still being written, but more cautiously, and with more connection to the value of the underlying asset.

In short, the decade's great experiment in direct, unmediated lending is undergoing an Adam Smith cleansing. Amid the credit mania, Wall Street's whiz kids pioneered new ways to lend and make money without the intermediation of traditional bank capital. It was very efficient, raising money from all corners of the world, and its benefits were real. But it was also more vulnerable to panic because, if the value of the underlying assets fell, there was little cushion to absorb the losses. When the housing and mortgage mania stopped, so did the confidence in those SIVs and the panic set in.

In his wisdom, the Professor from Glasgow is now moving more of those direct-lending assets back on bank balance sheets where there is a capital safety net to write off the losses without busting the entire financial system. The ratio of direct to intermediated lending is falling, while the banks themselves are getting access to new liquidity, both private and public through the Federal Reserve's discount window. This by itself is an enormous reform, and all of it is taking place without a single vote in Congress.

What will our new financial system look like once Professor Smith is done? It will be smaller for one thing, but perhaps safer. Securitization -- packaging assets and then selling them as securities -- will continue, though with more discipline. The system will be less efficient, and that's regrettable. But it may also be sturdier -- with a greater capital cushion, less leverage and better risk management -- and thus better able to ride out the next financial rough patch.

Or at least it will be if the Beltway doesn't pile on another dose of moral hazard. That's what the Fed did this month by guaranteeing that $30 billion in Bear Stearns mortgage paper for J.P. Morgan. As Yale's Jonathan Macey wrote on these pages yesterday, that action was a commitment of taxpayer dollars that almost certainly violated the Federal Deposit Insurance Improvement Act. If the government is going to commit taxpayer money to rescue banks, the proper vehicle is the FDIC. The Federal Reserve needs to maintain the quality of its balance sheet as a lender of last resort and to conduct monetary policy. Rather than rearrange the bureaucratic furniture, Congress could better spend its time digging into the Fed's Bear Stearns deal.

Today's credit panic isn't some "crisis of capitalism" that needs a vast new layer of regulation. We are living through the aftermath of a societal credit mania fueled by excessive money creation. The regulators are as much to blame as the regulated, and Adam Smith is providing more punishment and reform than Washington ever will.