I've been reading a fascinating (but admittedly heavy going) book about the credit crunch - 'How Markets Fail' by John Cassidy - which looks at the current financial crisis through the prism of economic and political theory. Okay I know that probably doesn't sound fascinating to most of you, but bear with me!

The book covers free-market heroes like Adam Smith and Milton Friedman and left-ish thinkers like Keynes and Minsky and shows how politicians and regulators distorted these theorists' ideas in justifying their actions. Nothing too surprising there, but what struck me was how polarised the debate about financial regulation and reform has become.

The arguments are too often presented a straight choice between, on one hand, liberty and the power of the market, and on the other, state intervention and socialism. Whereas in fact - at least from a theoretical perspective - the boundaries are much less clear and we should be able to have our cake and eat it!

For example, Adam Smith, the founding father of free market capitalism, was very clear in his writing that financial services was one market that could not be left to regulate itself. Smith's ‘invisible hand' - i.e. that supply and demand will ultimately find the equilibrium price - did not extend to banks and financial services, even before the emergence of things like mortgage backed securities and credit default swaps.

That advice seems to have been hopelessly ignored by the likes of former Chairman of the US Federal Reserve, Alan Greenspan, and even Gordon Brown during his time as Chancellor. US and UK politicians and regulators appear to have seen their role as getting out of the way as much as possible to let the market do its best. But the market throws up some very peculiar incentives, which are best described as ‘rational irrationality'.

Without boring you with ‘game theory' and ‘the prisoner's dilemma', what this basically means is that actions that may make sense for an individual (or an organisation) to follow can, when taken together, throw up a wholly illogical response. For example, it might make economic sense for one London Borough to transfer all its housing stock in order to reduce their maintenance costs, as people in housing need can be accommodated by neighbouring Boroughs. However, if all the London Boroughs were to follow the same (logical) path, it would lead to a situation that would be illogical (no council housing in London). The only way to sort out these perverse incentives is through government intervention and regulation.

The bailout of the banks has severely undermined the credibility of the efficiency of lax financial service regulation, but policy makers on both sides of the Atlantic continue to lack a clear vision of where we go from here. We need a new way of thinking about economics that acknowledges the usefulness of markets but also recognises their limitations.