Instead of quoting extensively from Paul Krugman's gigantic blog post about financial reform, let me instead try to summarize/explain the issue. Those who want a more general or advanced treatment should read the original post.
Basically, to have a rich economy you need a good financial system. Why? Well, there's several reasons, but one big one is this: All our fabulous wealth comes from productive enterprises (e.g. businesses). Building a productive enterprise takes a bunch of money ("capital"), and the only place to get that much money is from people's savings.
BUT, building any kind of a productive enterprise (such as a business) takes A) time, and B) risk. Businesses take a long time to start turning a profit, and there's a chance they will fail before they do. People don't want to put their savings into risky investments. People also want to be able to quickly withdraw their savings in case of emergencies. So most businesses are a bad investment for your average saver. If people all had to invest their own savings, we wouldn't have many businesses, and we would all be very poor.
This is where the financial system comes in. A financial company - e.g. a bank, or investment bank, or hedge fund - borrows your savings (in the form of, say, bank deposits), and promises to let you withdraw those savings whenever you want. It then takes that money and invests it in a whole bunch of different businesses. The financial company makes a profit because the businesses it invests in, on average, pay a high rate of return (when businesses succeed, they succeed big), but it only pays you, the depositor, a low rate of interest on your savings (which doesn't bother you, because you're more interested in low risk than high rewards).
A financial company "borrows short and lends long."
But this creates a danger. What if everyone demands their savings back at once? The financial company can't raise enough cash to pay everyone back at the same time, because most of its assets are those long-term high-return things. So if some kind of panic makes people all demand their money back at the same time (ever seen It's a Wonderful Life? Or Oliver?), the financial company fails. If a whole bunch of financial companies fail at the same time, there's a financial crisis, and businesses can no longer borrow the money they need to create those productive enterprises. The financial system is inherently fragile - inherently vulnerable to panics. This is bad.
So to prevent this from happening, the government gives the biggest financial companies (e.g. banks) insurance - the government promises to step in and support financial companies that fail (example: the FDIC). This gives the financial companies an incentive to make lots of risky investments, since they know that the government will back them up if they fail. So the government creates regulation to stop the financial companies from making too many risky investments. Financial companies can either accept government insurance and make few risky investments, or they can opt out of government insurance and make more risky (but potentially more rewarding) investments.
But there are three problems with this system. The first problem is that whenever you have regulation, you have people who spend time and effort trying to game the system instead of doing productive stuff. This is not to say that financiers are diabolical or evil or dishonest (though some probably are); most just have no way of knowing when an investment is truly productive or when it makes money from "regulatory arbitrage." The second problem, related to the first, is that regulators have a hard time stopping government-backed financial companies from making risky bets, because the companies are really good at hiding their risks. The third problem is that some non-insured companies, who make lots of risky bets, can become so big that they can hurt the financial system if they fail (e.g. Lehman Bros.).
Some people have suggested that we eliminate these problems by eliminating the government insurance system - that we just let finance companies fail if they fail, and that the fear of failure will stop them from making too many risky bets. There are two problems with this approach. The first problem is that finance companies sometimes make mistakes - they sometimes can't tell a risky asset from a safe one (example: CDOs). The second problem is that it's very difficult for the government to keep its promise not to bail out finance companies in the future - after all, the future government people will not be the same people who made the initial promise to let the financial companies fail. So "just let them fail" is not a workable idea.
Some other people have suggested that we simply stop banks from getting so big that their failure threatens the whole financial system. There are two problems with this approach. The first problem is that we don't know how big is too big - Lehman Brothers wasn't super-big, for example, and its failure still sparked a crisis. The second problem is that there are times when nearly ALL financial companies are threatened with failure at the same time - there are nation-wide panics that lead to nation-wide bank runs. In these cases, it doesn't matter how big any one financial company is.
So, according to Krugman (and I happen to agree), our best bet is to simply do what we've always done - try to improve our regulations, and force more companies to accept government insurance in exchange for following those regulations. This solution will eventually fail, because companies will find ways around those regulations. There will eventually be another financial crisis. Our best hope is to delay the day of that future crisis. There seems to be hope that we can delay it for a long time. It was almost 80 years from America's last big financial crisis to the one we're currently in. Roosevelt's FDIC (govt. insurance) and SEC (regulation) did a good job of delaying the next crisis.
Upshot: having a financial system is much much much better than not having one. To rail against "speculators" is foolish, because "speculation" is exactly what allows us to do long-term projects. Financial systems are fragile; even if 100% of financiers were 100% honest, the system would crash sometimes. Thus, financial systems seem to work better when they have some government insurance and some government regulation...but as far as we know, there is no way to stop the system from collapsing every once in a while. Those crashes are an acceptable price to pay for the wonderful modern society in which we live.
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