Hank Paulson, the Bush-era Treasury Secretary who spearheaded the 2008 bailouts, has an op-ed in the NYT today on how to fix finance. He’s got the right goal — ending too big to fail — but, like the Obama administration and Congress, he’d have us go about it backwards.

Paulson thinks that Washington can end too big to fail by saying it’s so:

The government needs broad-based authority to liquidate any failing financial institution. . . . We must send a clear signal to market participants that whenever this process is put in motion, the outcome is liquidation; we cannot leave any hope that we would inject taxpayer dollars to preserve the failing firm in its present form.

But there’s a reason that financial firms can’t go bankrupt. For two decades, the financial world has used financial instruments such as credit-default swaps to spread unknowable risk throughout the financial system. Washington applies no consistent cash-down rules to these instruments or the firms that use them to cover any mistakes, nor does it apply disclosure rules so that observers can see how much money is at stake.

Washington has got to employ these tried-and-true rules, which have long applied to other investment markets such as stocks, to govern unregulated markets.

Without such rules, giving the government official liquidation authority won’t avoid the need for future bailouts.

Even if Washington had had liquidation authority over AIG in the fall of 2008, the government still would have had to offer blanket guarantees to AIG’s trading partners — bailouts! — to avoid massive runs on the financial system. Because AIG had used unregulated derivatives to make opaque promises to undisclosed counterparties, investors had no idea where the risk was when AIG became unable to make good on its guarantees. So investors fled the entire financial system to escape the risk altogether — until the government made it clear that taxpayers would take on full responsibility for the unknown risk.

As Peter Eavis writes today, the fear that unregulated derivatives related to Greek debt could cause another meltdown is also likely behind Europe’s move to guarantee Greece’s creditors against default.

The American government may someday have the official authority to wind down a big financial firm. But it is never going to have the authority to wind down Greece.

Congress would be better off strengthening the financial system against the consequences of failure, rather than thinking that it can solve too big to fail by giving regulators the power to carefully manage failure when it happens.

Paulson, though, mentions derivatives reform not as central to ending too big to fail, but as a box-ticking afterthought.

Paulson’s other idea is a systemic-risk regulator so that we don’t have “different government regulators focusing on the individual trees,” but “one regulator accountable for looking at the entire forest.”

But Washington still doesn’t see the forest of this crisis — and it’s going to see the next one before it happens?

Original Source: http://corner.nationalreview.com/post/?q=ZDM3NmY1NDAwOTJkZDAwNzA4ZTdjNDY3Mzg4NWQ2YTY