Crisis shows need for strong regulation: Blinder

CHATHAM, Massachusetts (Reuters) - The concept of markets being able to regulate themselves should be jettisoned after "perhaps the greatest financial crisis the world has ever known," a top economist and former Federal Reserve official said on Friday.

"The case for laissez-faire in financial markets now looks extremely weak," Alan Blinder, economics professor at Princeton University, said in a paper prepared for delivery at the Boston Fed's economic conference in Chatham, Massachusetts.

"Regulation of financial businesses is readily justified by the needs to protect consumers from being duped, to protect taxpayers from shouldering large bills, and to protect citizens from the dangers of financial and macroeconomic instability."

The annual get-together in this Cape Cod resort town focused on what would emerge after years of extraordinary financial and economic crisis.

Blinder, a former Fed Vice Chairman, said it was inevitable in a massive economy like the United States that some financial firms would always be too big, or too interconnected, to fail without sending shock-waves through markets and the economy.

Still, that "too big to fail" doctrine "may have been abused by many of our once-illustrious financial companies. A variety of miscreants imposed enormous costs on innocent bystanders by dragging the economy down," he said.

Blinder instead suggested tweaking the concept that some see as the root cause of financial irresponsibility -- the implicit guarantee that the government will always step in, at whatever cost, to bail out certain firms.

"The too big to fail doctrine would morph into 'too big to be put into Chapter 11,' but not 'too big to be seized and its management thrown out.' That change alone would go a long way toward reducing moral hazard," Blinder said.

TIDE FLOWS OUT

"Three huge jagged rocks" were concealed by the high tide of a buoyant market, Blinder said: dysfunctional compensation systems for traders and top executives, sleepy or even irresponsible corporate boards, and the question of how much proprietary trading should be allowed in firms that have tacit or explicit government backing.

The Treasury's plan to slim down the maze of federal regulators were commendable but timid, Blinder said.

"Going down from six agencies ... to five hardly qualifies as a great leap forward," he said.

At the same time, Blinder said the Consumer Financial Protection Agency proposed by Treasury, which would take that role from the Fed, could fill an important gap in the regulatory framework.

"The Fed performed its consumer protection duties poorly and deserves to lose that authority -- not as a punishment, but because another agency, focused on the mission, will probably do the job better," he said.

Blinder said the road ahead for derivatives and hedge fund regulation was still unclear.

"Pushing the trading of as many derivatives as possible onto organized exchanges, and insisting on regulatory transparency from all sizable hedge funds, both of which the Treasury favors, strike me as valuable first steps," he said.

(Editing by James Dalgleish)