The Black Death of 1349 was a low probability, high impact event; so was the banking crisis of 2008, and the insolvency of Lehman Brothers. When such events do occur, political leaders are under pressure to respond, as the Emperor Hirohito of Japan had to respond to the atom bombs dropped on Hiroshima and Nagasaki in 1945. His comment was that the war had gone “not necessarily to Japan’s advantage”. Japan surrendered.

In the aftermath of the Black Death almost half the population died, resulting in an acute shortage of labourers. This shortage in turn led to higher pay and higher prices. King Edward III, who was one of the most successful monarchs in Europe, responded with a statute that fixed maximum wages.

This measure failed to prevent a further rise in wages and prices. Fifty years later legislation had extended to include fixed wages for bailiffs in cities and boroughs as well as rural districts. Pay controls, once adopted, have a nasty habit of spreading. If City bankers are to be controlled, why not lawyers or accountants?

Panic leads to pay controls and pay controls fail to achieve their objectives. When governments try to close the loopholes, they end up with failed regulation. Most politicians and most bureaucrats have a better knowledge of politics than economic history. They plunge their countries into a sea of largely ineffective regulations, in which some businesses swim but others drown.

In examining the policy options on banking regulations that face the G20, one should not forget the contribution that the regulators made to the 2008 recession. British regulators failed to foresee the recession. The banks may have failed badly in their judgment of risk, but so did the regulators, including the Treasury, the Bank of England and the Financial Services Authority.

It is not clear why further regulation should prevent another crash, when regulation did so little to prevent this one, and so much to make it worse. In particular, the retired Chairman of the Federal Reserve Board, Alan Greenspan, floated the United States economy on a tide of debt.

He was so afraid of the impact of a bubble imploding, that he always intervened to prevent it. When the dot.com bubble did implode, he allowed the sub-prime housing bubble to take its place and the housing bubble proved to be the more dangerous of the two.

In all this one should not forget the contribution of Bernard Madoff, or rather of the failure of the United States Securities and Exchange Commission (SEC) to detect what he was doing. They never did catch him before he handed himself in.

Last week the inspector general of the SEC, David Kotz, published his report into the fraud. It chronicled a series of warnings. For instance, as early as 2003 one hedge fund manager wrote to the SEC saying that he saw signs of a Ponzi scheme at Madoff’s New York business. SEC officials did start an investigation, could not understand the answers Madoff gave them, and went away to look into something else they could understand. They might have saved at least five years’ growth of what became a $40 billion fraud.

There is a simple reason why the bankers who receive bonuses can usually outsmart the regulators. It is because the bonus bankers take the jobs that offer the highest rewards; they earn more than the regulators.

Successful investment bankers can count their pay in millions, whereas regulators are paid at most in hundreds of thousands. The job of an investment banker is more exciting, even if the job of a regulator can be more secure. People who have the temperament of entrepreneurial bankers are not put off by the career risks of the entrepreneurial role. In any case, they are trained to find the best way through regulatory systems and to minimise taxes.

Oddly enough, it was not the taking of undue risks that was the detonator of the 2008 crisis. The common characteristic of the Madoff victims was that they were risk averse; they wanted a secure return, not a spectacular one.

Bankers were also largely risk averse. As Sir Martin Jacomb, a former director of the Bank of England, has put it: “At the heart of the catastrophe was a single regulatory error: the failure of Basel rules to impose weighty capital requirements on the super-senior tranche of securitised mortgage obligations held in banks’ trading books.”

Regulation pushed banks in all countries towards excessive holdings of these securitised mortgages that proved so lethal. The banks were not buying them as junk, high-risk securities but because they were attractive in terms of the capital requirement. Some bankers thought this too good to be true, and it was.

The G20 meeting in Pittsburgh at the end of this month will be a very grand affair, with President Obama in the chair. The meeting will receive a letter jointly signed by three European leaders, Gordon Brown, President Nicolas Sarkozy, and Chancellor Angela Merkel Their letter will call for a limit to the bonuses that bankers can pay themselves. It will not aim to control the individual remuneration of bankers, but would limit the size of the pool that might be allocated to bonuses. These might be calculated as a percentage of the bank’s turnover or profits. No viable scheme yet exists.

Investment banks are international and have complex corporate structures, partly shaped by taxation. Over time these structures change a great deal. A global scheme of pay control could lead to national losses if banks moved from strict financial systems to other centres where the regime was more flexible.

No doubt the G20 nations will agree to do something, if only to save their faces. Presumably they will proceed with some attempt to regulate bankers’ pay. Edward III was a great King, but not so good as an economist. Wage controls did not work for him, or for Ted Heath in the 1970s. I do not suppose they will work for the European leaders now.

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