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Treasury Secretary Henry Paulson’s proposal to consoldiate various financial regulatory agencies is uninspired and likely will prove useless.  This proposal rests on the unquestioned assumption that bad economic results should never occur, and, if they do on a large enough scale, should be bailed out by the government.  If they should be bailed out, then the federal government rightly acquires some interest in preventing them. But consolidation alone won’t do the trick, even if these flawed assumptions about the goals of economic regulation are accepted. 

Without new rules and expanded authority–which Paulson  has renounced–it’s unlikely any consolidation of the SEC, CFTC, OCC, and other regulatory agencies can yield better results than today.  This is the same logic behind joining various agencies under the Department of Homeland Security, which has accomplished little more than these agencies could in the past working seperately because of old fashioned rules on profiling and the lack of increased border infrastructure.  The case for consolidation is even less compelling in the case of finanical regulators, as poor inter-agency communication was widely reputed to be one factor in the 9/11 attacks.  By contrast, no one thinks that the current mortgage crisis is the result of some regulatory gaps or bad communication between the agencies.  Rather, investment banks, hedge funds, and other unregulated organizations now control huge amounts of the lending going on today and largely do their work off of the regulators’ radar. 

Investors know that these organizations are less regulated and more opaque than the regulated alternatives in the form of commercial banks and publicly traded companies.  The reason people still invest in these entities in spite of these demerits is a greater anticipated yield.  But everything comes at a price.  Investors of capital overseas, for instance, take the risk of other countries’ screwed up legal systems and greater degrees of corruption.  This is as it should be.  The whole point of regulation is to promote the proper pricing of risk and divert capital into safer investments at home to further American economic enterprise.  Bailing out investment banks and other holders of subprime mortgage instruments would instead reward high risk speculators, bailing them out of their risky choices, even as Paulson eschews more regulatory authority.

If the DHS is a good analogy to the proposed regulatory consoldiation, the best analogy for the Federal Reserve’s bailout of failing investment banks is the failed IMF strategy of bailing out the central banks of corrupt nations during the Asian currency crisis of the late 90s.  There, as in the US today, under-regulated high risk investments overseas attracted too much capital that underestimated the risks.  Investors seemingly forgot that the Third World is impoverished for a reason.  This led to a number of investment and monetary bubbles, which in turn burst.  Instead of allowing the devaluation to run its course, which it eventually did, the IMF at first bailed out Asian central banks and their investors leading to continued over-investment in “emerging markets.”  It would have been preferable if investors were forced to take their lumps as regimes as varied as China and Indonesia suffered the painful “correction” they deserved because of their instability and corruption. 

Our own Indonesia, the free-wheeling world of hedge funds and subprime securitized mortgages, needs to be shaken out so that in the future capital will not be invested to an irrationally high degree in high risk, underregulated investments.  Consolidating regulators and bailing out the failed investors is the worst of both worlds:   it increases public exposure without any concomitant increase in regulatory authority over the high risk institutions involved.

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