President Obama has announced a new plan to limit the size of banks and place restrictions on the trading and holding of assets of uncertain value by banks. “The American taxpayer will never again be held hostage by a bank that is too big to fail”, he said.

Much of the media attention has focused on the apparent attempt to use this initiative to shift to a more populist form of politics. Up to now, he has appeared quite timid about the question of bank re-regulation. Many analysts believe that this is because he is listening to his economic advisers, other than Paul Volker, rather than his political advisers who have sensed a restive public unhappy that the banks are not being brought under tighter regulation. Exceptionally, Mr. Volker, a former Federal Reserve Bank Chair, has advocated that Obama move on bank regulation, but the other orthodox economists have, amazingly, remain wedded to their belief in unregulated markets.

However Mr. Obama and Mr. Volker are right, as a matter of policy. If that coincides with the mood of the majority of voters, it is just another indication that the voters often get it right. The trouble with conventional experts on economics and social issues is they too often embrace orthodoxies and conventional wisdoms that mistake their belief systems for factual descriptions. Thank goodness for democracy, and its ability to force correctives in policy.

One fundamental problem with the conventional economists’ views on bank regulation is that it embeds a construction of an idealized world that among other things fails to distinguish risk from uncertainty. Risk can be measured and can be assigned probabilities. Uncertainty cannot. All that can be known about uncertain outcomes is that they can be very damaging if they occur. But the probabilities of different possible outcomes can’t be calculated. Thus it is not possible to insure against them, or to devise instruments that will act as natural counterbalances to them.

The complex derivative financial instruments that were used to finance the highly risky mortgages banks made were so opaque and confusing as to make it impossible to make risk calculations about them. This was the case with the so-called toxic asset backed paper that brought the banks down all across the world. Because they could not be assessed in terms of risk, they could not be insured against, and they could not be made subject to market discipline. The economists advising government were unable to see the implications of this because their education never let them think about market as institutions that can only work under certain situations, and their sluggish minds couldn’t grasp the significance of the difference between calculable risk and uncertainty. So they assured policy makers that risk is the only relevant or real idea, that any numbers are always better than no numbers (even if they are imaginary it seems) and that investors, who are by definition very smart, will always correctly assess risk and trade in instruments that will insure against massive bank failures that might otherwise arise from holdings of toxic assets.

The result that banks were left unregulated in terms of holding such assets. The economists pictured every bank as fully quipped with very smart risk assessors calculating to the millionth decimal point the risk and the appropriate risk protection strategies. It seems never to have occurred to them, and apparently still does not, that this couldn’t be done for the exploding class of derivative assets.

Some say that ii is not fair to criticize the economic advisers for not seeing the need to regulate the investment by banks in these kinds of assets because they were new innovations and their existence could not be understood. This is a faux criticism based on a narrow idea of what it means to understand something. From the 1930’s until the de-regulation of the 1980’s and 90’s, policy thinkers were a bit more broadly educated, and banks were prohibited from investing in any assets that carry these kinds of uncertainties and hard to calculate risk. And it worked. The problem was well known, even if the exact nature of the assets changes from time to time. It was the narrow minds of the policy makers and advisers, and the pressure from self interested financial community that caused governments to de-regulate, not the inability of intelligent humans to understand the problem.

Truth to tell, the conventional economist’s beliefs, and beliefs is all they were, suited their ideological conviction that regulation is a thing always to be avoided in favour of market based mechanisms. To rationalize this they had to construct the imaginary all knowing risk calculators as the actors who protected the whole system. But they were pure fiction, because the risks could not be calculated. The ordinary people, and now Obama, are fortunately a little more subtle and intelligent. They see the problem and they see a simple solution. If the risks associated with these assets can’t be calculated, its simple – don’t let the banks invest in them. It is simple to put in place regulations that block their ownership by banks. This Obama now intends to do, against the advice of his economists. He also intends to limit the size of the banks so that if some still make bad decisions with depositor’s money, they will be small enough when they fail so as not to threaten to bring the whole system down, forcing government to bail them out.

Obama’s and the people’s understanding is absolutely correct. Perhaps they should all get Ph.D.’s, but really it is just practical common sense. And to be honest, there are quite a few economists who agree. But they have been cast in the past as pro-regulation, which is a bad thing to be, and thus have been silenced by the dominant view within the profession. Price based instruments, the dominant view argues, are always better. So they still constantly talk about the challenges of pricing risk as the policy problem, and then excuse the banks because it is so, so hard to do in these cases. Which it is. Indeed it is impossible in these kinds of cases. But they are just wrong in defining the problem, as the experience of the last couple of years has clearly established, and thus fail in reasoning through what to do. It is of no policy use to sympathize with the banks for how hard it is, and to puzzle over how they might better price such risks in order to make policy. It is time for a more practical, intelligent, fact based analysis if we are to have good policy. If it is too hard to price risks, and banks don’t know enough to avoid them, the simple solution is to block the banks from holding such assets. Which means tough regulations that prohibit them from doing so. QED.