For a stark contrast in thinking about the cause and cure of the financial crisis, compare the recent speeches and proposals by Treasury Secretary Henry Paulson and Senator Barack Obama.
Paulson's plan would intensify the hands-off philosophy that invited the credit crunch. He would make the Federal Reserve a superagency to monitor large financial firms and provide emergency bailouts. He would reshuffle some federal agencies -- but actual regulation would be weakened. The plan proposes, "The Federal Reserve's authority to require corrective actions should be limited to instances where overall financial market stability was threatened." Other regulatory agencies are to defer to the Fed, and to "streamline" -- translation: water down -- existing rules.
Paulson views financial turmoil as a natural disaster rather than the product of bad policy. He declared, "I am not suggesting that more regulation is the answer, or even that more effective regulation can prevent the periods of financial market stress that seem to occur every five to 10 years." He also faulted the structure of regulatory agencies. But those agencies worked fine, back when presidents appointed people who believed in their mission.
On Wall Street, the Business Roundtable and the Securities Industry Association cheered Paulson's plan. But in Congress, the proposal seems dead on arrival. Chris Dodd, chairman of the Senate Banking Committee, said it "is a wild pitch."
Beneath the sports metaphor is a profound philosophical and empirical argument. Are we in a financial crisis because of too much regulation -- or not enough? At bottom, three kinds of abuses led to the current crisis, while President Bush's regulators stood idly by.
Paulson's plan addresses none of them. First, financial firms created credit by inventing exotic, little understood securities. There was scant disclosure to regulators or investors, who mistakenly trusted bond-rating agencies. Credit has now frozen, as markets belatedly downgrade these assets.
Second, conflicts of interest abounded. Middlemen, such as the brokers and banks that extracted large fees from promoting subprime securities, profited handsomely, while disclaiming knowledge of risks.
Third, permissive regulation allowed dangerous levels of leverage and debt -inviting a crash. For example, just before it went bust, Carlyle Capital, the investment fund sponsored by the prestigious Carlyle Group, had borrowed $32 for every dollar of its own capital.
The Federal Reserve has compounded these abuses by bailing out the casualties, without imposing standards in return. The Fed's bankrolling of a shotgun acquisition of Bear Stearns by JP Morgan Chase was so ill informed that a do-over was required a week later at five times the original price. This is the Fed that Paulson would give even greater discretionary powers.
In striking contrast to Paulson, Obama seems to grasp what has occurred and what needs to be done, namely a sweeping overhaul of federal financial regulation and not just more reliance on the Fed. "When the Fed steps in," he declared in his New York speech last week, "taxpayers have every right to expect that these institutions are not taking excessive risks."
Obama, unlike Paulson, proposes specific remedies -- far greater disclosure, tougher capital requirements, and strict prohibitions against conflicts of interest. Obama declared, "If you can borrow from the government, you should be subject to government oversight and supervision. Capital requirements should be strengthened. Transparency requirements must demand full disclosure by financial institutions to shareholders and counterparties." Obama also called for tough new regulations against conflicts of interest.
Harnessing Wall Street to serve the public interest will be a heavy lift politically. Some in Obama's party, such as his rival Hillary Clinton, have painted the mortgage crisis mainly as a self-contained problem, rather than a symptom of financial markets run amok. Last week, Clinton proposed naming two of the prime sponsors of deregulation, Alan Greenspan and Robert Rubin, as wizards to devise a solution.
As Paulson's ill-timed effort suggests, the free-market experiment has failed but the melody lingers on. There is still a large political undertow, from private financial elites that want government to stay out of their way. Despite the practical failure, it will take Roosevelt-scale political leadership to achieve a counterrevolution. If he's elected, we will find out whether that describes Obama.
This article originally appeared in the Boston Globe.