PETER S. GOODMAN ESSAY

From the earliest days of capitalism, those skilled at making money have proven creative at evading the regulators.

In the Middle Ages, when usury laws banned lenders from charging interest, savvy merchants lent in one currency and took repayment in another, thereby profiting without incurring the wrath of the Catholic Church. So much has happened over the ensuing centuries yet history remains unbroken: Time and again, financial innovation finds a lucrative path around regulation.

As the United States Congress and the Obama administration now enter the endgame in an effort to temper the dangers that delivered the worst financial crisis since the Depression, experts assume that this historical narrative will hold. If anything, swift advances in technology have made it harder for watchdogs to simply recognize the risks building within markets, let alone deliver effective action.

“The financial industry always finds ways to stay ahead of the regulators,” says Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard University. “Whatever law they design today, if it’s not updated in 15 or so years, it will be completely ineffective, completely irrelevant.”

Not that regulatory efforts are futile. The history of finance is full of crises that spawn regulatory steps, snuffing out trouble before a new variant pops up. The wildcat banking era of the 19th century, when banks in multiple states issued their own (sometimes worthless) currency, spurred the creation of a national bank supervisor. When opportunists and charlatans sold stocks to the public without disclosing the extent of their debts, culminating in the stock market crash of 1929, the federal government created the Securities and Exchange Commission.

The New Deal reforms imbued traditional banking with a sense of safety, but also encouraged financiers to seek out greater profits by taking risks in areas beyond regulatory purview. The resulting shadow banking system that emerged over the last quarter-century - the murky world of unregulated corporate insurance contracts and other flavors of so-called derivatives - nurtured the recklessness that ultimately metastasized into today’s global crisis. The government had effectively tamed the traditional banking business. Wall Street expanded to more adventurous terrain, erecting frontier-style casinos beyond the edges of regulation.

This shadow banking system came to specialize in innovations that created the illusion that risk was being responsibly managed; in crucial cases, they actually intensified the dangers. Financial innovation helped Greece mask the extent of its debt troubles, leading European banks to keep lending. That generated jobs for German autoworkers, whose creations landed on the streets of Athens before reality trumped illusion and crisis washed across Europe.

The very concept of financial innovation now seems compromised. Some derivatives have sown stability, enabling global companies to hedge against fluctuations in currency exchange rates. Yet many innovations with forbiddingly inscrutable names are now implicated in a ruse designed to convey a sense that risk was being diluted when it was really being amplified and spread worldwide. When the insurance policies failed and the losses piled up, ordinary people lost trillions of dollars in wealth, homes and jobs.

Some argue that regulators were effectively duped into complacency by financial institutions skilled at managing the perception of risk (even as they proved less skilled at managing risk itself).

Given the impenetrability of Wall Street, some argue that we have no other option but to rely on financial insiders to staff regulatory agencies: When you need to defuse a bomb, you hire someone intimately familiar with explosives.

“If we take the view that only people who come from an academic background, people who don’t have any experience, can serve in regulatory agencies, we will have an impoverished government,” says Eugene A. Ludwig, comptroller of the currency in the Clinton administration and now chief executive of the Promontory Financial Group. “These human foibles are going to be with us forever.”

EDEL RODRIGUEZ