Obama's Plan -- A Regulatory Mess

If President Obama's financial regulations are adopted, there will be fewer loans, credit will be more costly, and individuals will face more risk. Obama argues today that his reforms are necessary to prevent "a second Great Depression" from occurring, but he does nothing to fix what the government did. Nothing is done to reform Fannie Mae and Freddie Mac, despite their problems with fraud and costing taxpayers $400 billion in bailouts. Nothing is done to change government regulations that force banks to make risky mortgages.

The powers that would be given to the president and the Federal Reserve are unprecedented. The bill gives the government the power to regulate the capital, liquidity and permissible activities for a long list of firms, including securities firms, insurance companies, bank holding companies, hedge funds, finance companies as well as others. The government will be also able to limit the size of these companies.

The president claims today that he "believe(s) in the power of the free market." Yet, he is constantly demonizing companies. Even liberal New York City Mayor Michael Bloomberg warned: The bashing of Wall Street is something that should worry everybody. According to Obama, there is "an ethic of greed, corner cutting, insider dealing, things that have always threatened the long-term stability of our economic system." In contrast, for government, Obama identifies its only failure as not doing enough regulation, not doing enough to control companies.

The regulations demonstrate that the president ignores or doesn't care to know how markets operate. Take one of his five "key proposals" today: the “Volcker rule,” to limit the size of banks. Alas, what the president never asks is: why have these banks grown so large? He seems to assume it is because they are just lucky or that they have been up to no good. In fact, there is a better explanation: the companies that grew large did so because they were able to offer better services than their competitors. Sometimes larger banks may also be able to provide services at lower costs. Large loans often times involve getting multiple banks together, requiring complicated negotiations, and large banks can sometimes make loans without having to bear all those costs.

Preventing banks from being large means these efficiencies will be lost. Loans will be more costly and there will be fewer of them.

Take another of his proposals: to "bring derivatives and other complicated financial instruments out of the dark," by forcing them to be traded on registered exchanges and to be approved by regulatory bureaus. Sounds fine, right? But he ignores why firms or people make deals between themselves rather doing everything on exchanges.

Derivatives are often a type of insurance. For instance, farmers trade in derivatives when they sell the crops they harvest in the fall before they even plant them. Why do they do that? So that they know beforehand how much they will get paid. Thus they know what and how much to plant without bearing any price risk. Regular firms often do the same thing. Sometimes a simple deal between two companies makes a lot more sense than having to make that deal on an exchange. Yet, if you require that these companies go through a costly and time-consuming regulatory process, they won't do it as often and they won't be buying the insurance they otherwise would have gotten.

In another of his proposals today, Obama says that he wants to stop government bailouts of companies. And that should be the goal. Otherwise, firms have an incentive to take too many risks when they keep their profits but taxpayers pick up their losses.

Who wouldn’t head straight to Las Vegas if you got to keep your winnings and the taxpayers picked up your losses?

But Obama’s solution though is to still allow bailouts, but try to prevent them from becoming necessary by stopping financial institutions from taking what he considers to be risky behavior. Of course, as just noted, not all his rules will do that -- preventing some derivatives from being traded means less insurance, surely increasing the risks that those firms face.

Senator Chris Dodd, the author of the Senate financial reform bill that Obama supports, adamantly accuses the Republicans of lying when they point out that the banking regulation bill will allow government bailouts of Wall Street. "It’s just a Wall Street lie. This bill ends bailouts," Mr. Dodd claimed on the Senate floor last week. Yet, even Democratic Senate leaders acknowledge that the bill puts aside a $50 billion fund for bailouts. Even without a formal bailout fund, the bill still provides bailouts through a treasury-backed credit line as well as giving FDIC wide latitude to make payments to anyone in any amounts, at their own discretion.

There is an alternative approach to stopping bailouts: ban them. Of course, a constitutional amendment to forbid bailouts might be the only practical solution at this point to preventing them for good. After all, with the recent bailouts, everyone expects that is government’s role.

The benefit of just banning bailouts is that there won’t be the incentive for companies to take excessive risks and there won’t be any need to micromanage how companies operate. If they make a risky investment, they bear the loss.

The government caused the current financial crisis by forcing banks to make bad mortgages. And the solution is less, not more, government control. Former Federal Reserve Chairman Alan Greenspan’s explanation this month before the Financial Crisis Inquiry on what caused the crisis is correct: "While the roots of the crisis were global, it was securitized U.S. subprime mortgages that served as the crisis' immediate trigger. The surge in demand for mortgage-backed securities was heavily driven by Fannie Mae and Freddie Mac, which were pressed by the Department of Housing and Urban Development and the Congress to expand affordable housing commitments." Unfortunately, Fannie Mae and Freddie Mac weren't the only government agencies to feel the pressure. Mr. Greenspan also noted, "I sat through meeting after meeting in which the pressures on the Federal Reserve -- and on, I might add, all of the other regulatory agencies -- to enhance lending were remarkable."

The government really isn’t very good at making business decisions. It has neither the expertise nor the incentive to run companies correctly. Nor is it likely that government can keep politics out. If we really want to stop bailouts, let us tie the government’s hands with a constitutional amendment.

John R. Lott Jr. is a FOXNews.com contributor. He is an economist and the author of "More Guns, Less Crime (University of Chicago Press, 2010), the third edition will be published in May.".