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Commentary By Nicole Gelinas

No Free Markets in Finance

Economics Finance

It's not the government's job to prevent the failure of financial firms like MetLife.

As President Barack Obama enters his final three months, he leaves behind unfinished business: what to do about the fact that large financial firms are still too big to fail and thus exempt from free market rules of success and failure. A current court case is the latest evidence.

The case concerns the Dodd-Frank Wall Street Reform and Consumer Protection Act, which Obama signed into law nearly six and a half years ago. One of the law's main goals was to ensure that taxpayers never again have to bail out investors in banks, insurers or other large financial firms.

“The government's job isn't to prevent failure but to protect society from the social costs of that failure...”

To achieve this goal, Dodd-Frank directed government regulators to designate some companies as "systemically important" – that is, so big or otherwise important that their failure could threaten the country's financial stability. The idea was that once regulators identified these firms, the regulators could ensure that the firms don't fail, by forcing them to limit their borrowing and otherwise supervising "overall risk management."

Starting next week, a higher court will hear the government's appeal of MetLife's win. The case likely will go to the Supreme Court after that.

But a court ruling for either side would not improve the environment for real free markets, in which even large firms can go bankrupt. If the government wins, it can go on signaling to the world that a firm like MetLife is too big to fail, without having to assess the risks of MetLife's failure or the cost to MetLife of ensuring it doesn't fail. But if the government loses, regulators can just tweak their processes under the existing law. That is, regulators could simply analyze MetLife's probability of failure and weigh it against the cost.

This so-called fix would not solve the fundamental problem: It is impossible for the government, or anyone, to accurately assess MetLife's chances of failing. The world's most highly paid investment analysts try to perform this job every day, and still they often get it wrong. That is why so many people lose so much money when firms do fail. And perversely, if the government were to determine that MetLife has, say, a 1 percent chance of failing, the determination would signal to investors that the firm is safe – thus causing even more economic instability were it to fail.

There's no way around it: Even if government regulators perform their jobs perfectly under Dodd-Frank, they cannot see the future. Large financial firms will fail. They have done so throughout history.

The government's job isn't to prevent failure but to protect society from the social costs of that failure: protecting individual life insurance policyholders if their insurer goes bankrupt, rather than protecting investors in that insurer.

Doing this job backwards – keeping firms from failing because social cost of their failure is too great – socializes free market capitalism itself.

This piece originally appeared in U.S. News & World Report

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Nicole Gelinas is a senior fellow at the Manhattan Institute and contributing editor at City Journal. Follow her on Twitter here.

This piece originally appeared in U.S. News and World Report