Saving Regulation From Itself

The Times' Dealbook reports:

Paul A. Volcker, a top White House economic adviser... [and] former Federal Reserve chairman, told Congress that by designating some companies as critical to the broader financial system, the administration’s plans would create an expectation that those companies enjoy government backing in tough times...

He urged lawmakers to make clear that nonbank companies would not be saved with federal money... he took "as a given" that banks would be bailed out in times of crisis.

Volcker makes reasonably explicit what I claimed in my previous post, that the intent of the administration is to insulate "critical" firms from market discipline. Smaller firms, attempting to operate without governmental guarantees will be at an obvious disadvantage competing against firms blessed as "critical". Costly and complicated regulation being considered in the name of weeding out systemic risk will create significant barriers to entry serving to further defend "critical" firms from the threat of meaningful competition.

Theoretically, as the President outlined, this may entail such firms being subject to increased regulatory scrutiny to ensure they do not take undue risk. In practice, even this will not likely come to pass. It is unclear that such regulation would be, in any way, more onerous then that which smaller firms will be subject to in the name of filling gaps in the regulatory fabric. It is unclear that the politically influenced regulators will serve to dampen, rather than spur excessive risk taking. Finally, it is unclear with what degree of seriousness we can take anything the President said considering the as-a-given dismissive-ness, his senior economic adviser treated the declaration of intent, in the same speech, to "put an end to the idea that some firms are 'too big to fail'."

In that politically astute speech, the President captured the common sense lesson reasonable people took away from the credit melt down: Too big to fail is too big. Washington's regulatory class, apparently, learned the opposite lesson: Not too big to fail is not big enough.

This is a clarifying moment, as Republicans have no real ability to influence the outcome. If, as appears likely, the administration, under the banner of tighter regulation, uses the power of government to distort markets in the service of large Wall Street banks, Democrats will not be able to blame corrupted Republicans. Rather, it will demonstrate, as clearly as can be, corruption in the heart of the idea of regulation.

If the goal of the regulatory class is to protect capitalism from itself, who, or by what means, will they (and we!) be protected from themselves?