This post is by Peter J. Wallison of the American Enterprise Institute.
There is a really bad idea circulating in the nation’s capital. Of course, that’s not surprising–but when it’s endorsed by the Treasury secretary, we’d better pay attention.
Recently, Henry Paulson said in an interview with the Washington Post that he wants the Federal Reserve to be able to regulate and ultimately take over any failing financial institution that it considers crucial–including hedge funds. This echoes a notion that has been endorsed by executives of some industry associations, that to prevent a recurrence of today’s financial crisis it will be necessary to impose tough new regulations on financial institutions deemed “systemically significant.”
If this approach were to be adopted in the panicked Washington of today, it would substantially change our financial system and guarantee–rather than prevent–future crises.
For starters, because the definition of a systemically significant institution is highly dependent on context, it’s impossible to identify one in advance. Consider Drexel Burnham Lambert. When it failed in 1990 it was one of the largest securities firms in the United States, not much smaller in relation to the market at the time than Lehman Brothers was when it collapsed earlier this year. Yet Drexel’s collapse, which happened when the market was functioning normally, did not put the financial system or the economy at risk.
