The "Greenspan doctrine" on monetary policy says that the Fed should not attempt to check asset price surges ahead of time but just manage the aftermath if they turn out to be bubbles and eventually burst. Such bubbles are difficult to detect before they actually burst, and a consistent policy intended to check presumed bubbles would reduce the economy's long-term growth potential. The job of regulating asset prices rests with market participants whose interests motivate self-regulation against undue market-risk exposures.

But in a speech last week, Fed governor Don Kohn said that "central banks are being encouraged to 'lean against the wind' in the face of asset price bubbles. We need to be honest about our very limited ability to assess the 'fundamental value' of an asset or to predict its price. Research should help to identify risks and inform decisions about the costs and benefits from a possible regulatory or monetary policy decision attempting to deal with a potential asset price bubble."

This suggests a re-thinking of the Greenspan doctrine within the Fed. The recession that began in 2007 has been enormously costly in terms of output and job losses. It is not surprising that Fed economists are examining whether monetary policy could prevent such episodes in the future instead of simply "mopping up" after the fact.

It's well known that the Fed successfully averted economic meltdowns after Wall Street swooned on several occasions: the stock market crash of 1987, its intervention to resolve the LTCM failure during 1998 and the even sharper bursting of the stock price bubble in 2001.

However, memories of those "successful" Fed interventions may have spurred even larger subsequent surges in asset prices because of their moral hazard effects on investor attitudes toward risk. Although other factors such as ratings errors and improper SEC regulations were important contributing factors, the recent financial collapse would not have been as severe without prior Fed-induced moral hazard among investors. So should the Fed now be formally vested with the responsibility of containing asset price bubbles pre-emptively and regulating financial firms?

Economists have long lamented problems in assessing whether asset price increases constitute bubbles and in predicting the timing of asset price bubble bursts. Setting capital standards and ancillary regulatory frameworks for financial institutions is more art than science. Given economists' poor predictive ability in evaluating macroeconomic risks and setting appropriate capital buffers for financial institutions, the Fed is bound to eventually (and spectacularly) fail at preventing asset price bubble bursts followed by severe financial disruptions. Then calls for congressional investigations and oversight on monetary policy would threaten the Fed's independence.

Indeed, making the Fed a financial super regulator would only provide formal sanction to policies that have increased moral hazard effects in the first place. Once the current recession is over and the Fed has withdrawn its extra-normal initiatives to restore credit markets, the correct policy approach may be to do the exact opposite — to signal that there will be no super regulator for financial institutions and to formally prohibit the Fed from engaging in bailouts of non-bank financial firms. Such a formal stance by Congress on financial regulatory policy is the best bet for developing mechanisms for sustained and effective self-regulation by market participants.

Fed officials are probably well aware of the dangers of accepting responsibility for setting financial regulatory standards and using monetary policy to prick asset price bubbles. The dangers are in setting anti-bubble policies that are so draconian they reduce the economy's long-term growth potential and eventually fail to protect financial institutions and the economy from a large macroeconomic shock. Such failures could permanently compromise the Fed's independence in monetary policymaking.

Although Fed analysts will doubtless continue research on the causes of asset price bubbles, they would be foolish to accept formal responsibilities for pre-emptively containing asset price surges and becoming financial super-regulators.

Total losses from the bailout of Fannie and Freddie are likely to exceed $250 billion — as much as the cost to the taxpayer of all bank failures in American history combined.

Fannie and Freddie infected capital markets and spread through every sector of the banking system. Before the bursting of the housing bubble, holdings of government-sponsored enterprise (GSE) securities — bonds and mortgage-backed securities as well as preferred stock — constituted more than 150% of core capital for insured banks.

It was not only the commercial banking system that was stuffed with toxic GSE holdings; it was also many of the investment banks. More than 50% of Maiden Lane One, the toxic assets that the Federal Reserve guaranteed in order to persuade JPMorgan to buy Bear Stearns, are GSE securities.

Additionally, more than 40% of money market mutual fund holdings were in the form of GSE securities.

The threats to the stability of the mutual fund industry were not simply a result of Lehman's failure. Had the government not bailed out Fannie and Freddie, many funds would have "broke the buck."

Save A Chinese Bank

Quite simply, Washington fostered an environment where if Fannie and Freddie caught a cold, the banking system would catch a fever.

Fannie and Freddie were the weak links in our domestic financial system. They were also the vehicles that carried excess world savings into America's housing market.

At the height of the bubble, almost 60% of newly issued GSE debt was purchased outside the U.S. One of the largest purchases of that debt was the Chinese Central Bank.

What did Fannie and Freddie do with their foreign borrowings? They invested in the subprime mortgage market.

At the height of the bubble, Fannie and Freddie purchased more than 40% of the private-label subprime mortgage-backed securities. Between the two of them, they were the largest single source of liquidity for the subprime market.

Interestingly enough, the very vintages of subprime loans that performed the worst — 2006 and 2007 — were the years in which Fannie and Freddie entered the market in force.

With their massive leverage, Fannie and Freddie were levered more than 100-to-1 — a disaster waiting to happen.

Why then were foreign investors so willing to trust their money to Fannie and Freddie? Quite simply, they were assured by U.S. Treasury officials that their losses would be covered.

Ultimately, Fannie and Freddie were not bailed out in order to save our housing market; they were bailed out in order to protect the Chinese Central Bank from taking losses. Without the implicit federal guarantee of Fannie and Freddie, trillions of dollars of global capital flow would not have been funneled into the U.S. subprime mortgage market.

Protect Taxpayers

Some might argue that the problem with Fannie and Freddie was fixed with last year's regulatory reform bill. That bill created a new regulator, one with increased supervisory powers, including the ability to wind down a GSE, and independence from the congressional appropriations process, letting the regulator raise additional funding.

Nothing could be further from the truth. As one of the drafters and negotiators for that bill while on the staff of the Senate Banking Committee, I can say that there was a shared awareness by all parties that the bill was insufficient to prevent the failure of Fannie and Freddie.

It was not the best bill that could be crafted. It was the best bill that could pass, given the continued strength of Fannie and Freddie apologists in Congress.

Nothing in the bill would have prevented the GSEs' massive accumulation of subprime mortgage-backed securities. Nor would the bill have deterred the GSEs from purchasing the many whole loans that have soured on them.

With their "strengthened" affordable-housing goals, the bill encourages GSEs to extend those purchases.

Had the reform bill that passed been signed into law years earlier, we would be in the same spot with Fannie and Freddie.

Most of the worst economic and financial crises in American history have involved real estate. Such is likely to be the case in the future. Reform of Fannie and Freddie is imperative so that American taxpayers will not be on the hook for hundreds of billions of dollars for the next real estate bubble.

This view is a pipe dream. Most new regulation will do nothing to limit crises because markets will innovate around it. Worse, some regulation being considered by Congress will guarantee bigger and more frequent crises.

Government-Induced Moral Hazard Caused the Crisis

The Financial Crisis of 2008 did not occur because of insufficient or ill-designed regulation. Rather, it resulted from two misguided government policies.

The first was the attempt to promote homeownership. Numerous policies have pursued this goal for decades, and over time they have focused mainly on homeownership for low-income households. These policies encouraged mortgage lending to borrowers with shaky credit characteristics, such as limited income or assets, and on terms that defied common sense, such as zero down payment.

The pressure to expand risky credit was especially problematic because of the second misguided policy, the long-standing practice of bailing out failures from private risk-taking. This practice meant that financial markets expected the government to cushion any losses from a crash in mortgage debt. Thus, the historical tendency to bail out creditors created an enormous moral hazard.

One crucial component of this moral hazard was the now infamous "Greenspan put," the Fed's practice under Chairman Alan Greenspan of lowering interest rates in response to financial disruptions that might otherwise cause a crash in asset prices. In the early to mid-2000s, in particular, the Fed made a conscious decision not to burst the housing bubble and instead to "fix things" if a crash occurred.

It was inevitable, however, that a crash would ensue; the expansion of mortgage credit made sense only so long as housing prices kept increasing, and at some point this had to stop. Once it did, the market had no option but to unwind the positions built on untenable assumptions about housing prices. Thus government pressure to take risk, combined with implicit insurance for this risk, were the crucial causes of the bubble and the crash. Inadequate financial regulation played no significant role.

New Regulation Must Avoid Moral Hazard

If government-induced moral hazard caused the crisis, then new regulation should avoid creating or exacerbating this perverse incentive. Yet two components of proposed regulation will increase, rather than decrease, the chances for moral hazard.

One proposed change in regulation would give the Federal Reserve increased power to supervise financial institutions, especially bank holding companies such as Citigroup or Bank of America. This approach is a triumph of hope over experience. Why should an expanded Fed role be beneficial when the Fed erred so badly in the previous instance?

Defenders of an expanded Fed role will claim that, in the lead up to the crisis, the Fed did not have explicit powers to supervise and monitor non-bank financial institutions, and that such powers could have avoided the crisis.

Yet during the years before the crisis, the Fed had more than ample power to recognize the unprecedented level of risk that was building in the economy and to issue stern warnings, whether or not it had explicit regulatory authority. In fact, far from cautioning the market to behave, the Fed promoted the notion that it could solve any problems that might result from a bursting of the housing bubble.

Regulators are fallible. Alan Greenspan, once thought to be the Maestro, got it fabulously wrong. Ben Bernanke, regardless of the merit's of his stewardship, will not be Fed chairman forever. Centralized and expanded power to make things better is also centralized and expanded power to make things worse. In particular, any mistakes made by a powerful, centralized authority have a magnified impact because they distort the behavior of the entire market.

Just as problematic as granting the Fed additional powers is the proposal to allow the FDIC to resolve bank holding companies using taxpayer funds. Under the proposed arrangement, the FDIC rather than bankruptcy courts would be responsible for bank holding companies, and the FDIC would be authorized to make loans to failed institutions, to purchase their debts and other assets, to assume or guarantee their obligations, and to acquire equity interests. The funds would be borrowed from Treasury.

This means that FDIC resolution of bank holding companies would put taxpayer skin in the game, a radical departure from standard bankruptcy and an approach that mimics the actions of the U.S. Treasury under TARP. Thus, the new approach would institutionalize TARP.

The result will be that under the proposed system, bank holding companies would forever more regard themselves as explicitly, not just implicitly, backstopped by the full faith and credit of the U.S. Treasury. That is moral hazard in the extreme, and it will create an unprecedented incentive for excessive risk-taking by these institutions.

The Bankruptcy Approach

The only way to limit financial panics is to eliminate government-induced moral hazard, and that means letting failed institutions fail. Whether resolution is carried out by the FDIC or a bankruptcy court is not the crucial question; rather, it is whether that resolution process forces all the losses on the institution's stakeholders rather than bailing them out with taxpayer funds.

The standard objection to allowing failures is that some financial institutions are allegedly so large or interconnected that their failure causes a breakdown of the credit mechanism, thereby harming the whole economy rather than just transmitting losses that have already occurred. According to this view, letting Lehman Brothers fail was a crucial mistake that initiated the meltdown, and bailing out other financial institutions was a necessary evil to prevent even further chaos. Nothing could be further from the truth.

Rather than being a cause, Lehman's failure was merely the signal that time had come for the U.S. economy to pay the price for all the distortions caused by the misguided policies toward housing and risk. Given those distortions, a massive unwinding and restructuring was necessary to make the economy healthy again.

This restructuring required lower residential investment, declines in stock and housing prices, and shrinkage of the financial sector. All of this implied a recession, even without any impact of financial institution failures on the credit mechanism, and the recession meant that lending would contract, even without a credit crunch.

The bailout itself, moreover, caused much of the financial market turmoil. The announcement that the Treasury was considering a bailout scared markets and froze credit because bankers did not want to realize their losses if government was going to bail them out. The bailout introduced uncertainty because no one knew what the bailout meant. The bailout did little to make balance sheets transparent, yet the market's inability to determine who was solvent was a key reason for the credit freeze.

Thus letting Lehman fail was the right decision; bailing out Bear Stearns, Fannie, and Freddie in advance of Lehman, and the rest of Wall Street afterwards, were the mistakes. For all its warts, bankruptcy rather than bailout is the right way to resolve non-bank financial institutions. Any regulation that formalizes bailouts creates an enormous moral hazard and a black hole for taxpayer funds.

The Future

To limit future financial crises, policy must first avoid the distortions inherent in the attempt to expand homeownership. This means eliminating the Federal Housing Administration, the Federal Home Loan Banks, Fannie Mae, Freddie Mac, the Community Reinvestment Act, the deductibility of mortgage interest, the homestead exclusion in the personal bankruptcy code, the tax-favored treatment of capital gains on housing, the HOPE for Homeowners Act, the Emergency Economic Stabilization Act (the bailout bill), and the Homeowners Affordability and Stability Plan. None of this is sensible policy.

In addition, policy must end its proclivity to bail out private risk-taking. This second task is difficult, since it requires policymakers to "tie their own hands." Specific changes in policies and institutions can nevertheless support this goal. The first is avoiding new regulation that makes bailouts more likely. A second is repealing all existing financial regulation, since this would signal markets that they, and only they, can truly protect themselves from risk.

The third and perhaps most important way to reduce moral hazard is to eliminate the Federal Reserve. As long as the Fed exists, it will regard itself as, and be regarded as, the economic insurer of last resort. In a world with perfect information, appropriately humble central bankers, and an absence of political influence on monetary policy, such a protector might enhance the economy's performance on average.

In the world we live in, none of these conditions will hold consistently, so the potential for policy-induced disasters is large. The U.S. economy prospered for its first 125 years without a central bank. It's time to try that approach again.

Executive pay has emerged, once again, as a major issue in Washington. This week Treasury and the Federal Reserve announced new regulations designed to oversee and limit executive pay at thousands of financial institutions. This is deeply ironic, because today's pay woes are the direct result of prior government intervention.

In 1993, Congress decided it would use the tax code to "improve" (i.e., reduce) executive compensation in publicly traded companies. Its vehicle was the Budget Reconciliation Act, a key provision of which became Section 162(m) of the Internal Revenue Code.

Noting that executive compensation levels had received negative "scrutiny and criticism" from the public, the new law targeted what it called "excessive employee remuneration." It did so by limiting the ability of public companies to deduct executive compensation for its top employees unless the compensation was paid out in a form that Congress found acceptable. Salary was bad. Stock options were tax favored.

Specifically, corporations were barred by law from deducting as a normal business expense any salary payments of over $1 million. Stock options, however, qualified for the corporate tax deduction without limitation. Much maligned today, stock options then were said to be "performance based" and therefore exempt from the new tax rules.

The new tax law immediately led to a tectonic shift in the way CEOs and other top U.S. executives were paid. Stock and stock options became the dominant feature of executive compensation packages.

The impetus for changing the executive compensation laws back then was exactly the same as it is today. Politicians wanted pay lower and wanted to change the executive compensation model to "fix" the risk-taking proclivities of top managers.

In 1992, the government thought that managers were too risk averse. Stock options were seen as the magic bullet for making managers act more aggressively in the shareholders' interests. Today, many in Congress are blaming U.S. executives for causing the financial crisis precisely by engaging in "excessive" risk-taking. What they fail to mention is that it was Congress's own tinkering with the tax code that led to the very compensation packages that incentivized the risk-taking.

Fed Chairman Ben Bernanke asserted this week that "compensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability." Mr. Bernanke promised that the government "is working to ensure that compensation packages appropriately tie rewards to longer-term performance and do not create undue risk for the firm or the financial system."

Other government interference has made the executive compensation problem even worse. A provision in the 1992 tax law required that executives meet certain "objective" performance measures in order to qualify for incentive-based (tax deductible) pay. In the scramble to come up with objective metrics on which to base executive pay, cottage industry "executive compensation consultants" emerged as the most important architects of executive compensation plans.

The compensation consultants promised to design pay programs that did things like "drive the right behaviors" by corporate management, which meant assuming more risk to maximize shareholder value. Public companies hired droves of consultants to analyze pay schemes and design pay packages that created incentives to maximize share prices. Consultants came to be viewed as essential to boards of directors that wanted to implement appropriate—and tax qualified—performance measures.

The most successful consultants are those who can justify the biggest salary increases for the top executives of the companies that hired them. Researchers at the University of Southern California recently found that the median CEO compensation is $1.5 million in companies not using executive compensation consultants, $3 million in companies that purchase general survey data from such consultants but do not directly retain them, and $4.2 million in companies that retain consultants.

Some companies use multiple consultants. The USC study found that the more consultants a company hires, the more it pays its top executives. About one-quarter of Fortune 250 companies hire multiple compensation consultants.

Activist investor Carl Icahn summed the situation up well when he recently observed on his Web site that "the use of these compensation consultants, gives both boards and CEOs the appearance of legitimacy for their decisions to award massive pay packages to lackluster CEOs, making it appear that these decisions are objective and scientific, which they absolutely are not."

The government also has tried to regulate executive compensation by requiring greater disclosure of the details of compensation plans. Perversely, this too has contributed to an increase in executive pay.

How so? No self-respecting board of directors is willing to admit that their company's CEO is below average. So anytime the new disclosures indicate that an executive's pay is below average in any way, a pay increase is ordered.

Since the early 1990s, government regulation of executive compensation has encouraged greater share-price volatility and risk-taking by U.S. corporate executives and led directly to higher, rather than lower, levels of executive compensation. Nevertheless, the Obama administration is now seeking an even greater role in overseeing and regulating executive pay.

In June, Gene Sperling, a top aid to Treasury Secretary Tim Geithner, told the House Committee on Financial Services that "our goal is to help ensure that there is a much closer alignment between compensation, sound risk management and long-term value creation for firms and the economy as a whole."

This is just what the regulators told us back in 1992. Current proposals will no doubt result in even higher percentages of executive compensation coming from stock and option schemes rather than from salaries. History teaches that the most profound consequences of new compensation regulation will be unintended. It also teaches that as bad as private ordering may have worked in getting executive compensation right, the results of central planning have been even worse.

We are skeptical that economists can detect bubbles in real time through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy. Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.

Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

How should we design our financial and regulatory institutions? The lesson from the 1970s was that rampant inflation and unchecked inflation expectations would eventually create obstacles to proper resource allocation and growth. So we established the Fed's mandate to promote maximum growth while delivering price stability. The current episode suggests that the Fed's current policy goals and instruments are not sufficient to prevent "inflationary" asset prices and price expectations.

The knee-jerk response by some observers has been to blame the Fed's conduct of monetary policy. Some observers suggest that the Fed should regulate financial companies more tightly, others that it should broaden the definition of price stability to include asset prices, and yet others that the Fed's objectives should be broadened to include prevention of asset price bubbles.

Some observers, especially European policymakers, have called for tighter regulation of financial institutions under a new global financial architecture. And the immediate response of governments all over the world has been to attempt to salvage the existing financial institutions, instruments, and arrangements by injecting massive taxpayer funds into the financial companies that are skirting economic collapse.

When will this process end and where will it lead? Recent government interventions have now almost certainly created expectations of similar future bailouts during the next financial crisis. That means banking institutions will feel more at ease in expending considerable efforts at skirting whatever new regulations are created to prevent a similar financial crisis from recurring.

Thus, the cat-and-mouse game of regulatory arbitrage in search of profits may intensify, rather than disappear, as a result of adopting stricter financial regulations. But, for a time, stronger capital and risk regulations may stifle financial intermediation and slow the pace of recovery from the current recession.

Some analysts are proposing the adoption of smart regulations that are sequenced and modulated according to movements in macroeconomic variables such as the capital standards that vary with the business cycle. One could call such regulatory measures "financial automatic stabilizers." However, as recent experience with fiscal stimulus packages shows, political pressures prevent politicians from leaving such systems well enough alone.

Any whiff of financial-sector problems will incite Congress and Treasury bureaucrats to tinker with the rules. Which institutions and officials are likely to be sufficiently prescient to correctly calibrate such regulations each time the financial sector hiccups? And would politicians be able to resist calls for regulatory relief when financial sector lobbyists flood their offices as profit opportunities surge? Even more likely, any new regulatory attempt to globally control profit-driven risk-taking will spur new attempts to circumvent regulations.

The key lesson from the current financial crisis and recession is that a government-imposed financial architecture is unlikely to persist for any significant length of time. Global market developments, and the need to channel resources toward opportunities perceived to be the least risky and most profitable, will continue to modify institutional financial arrangements. Imposing onerous financial regulations will only impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth.

Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

But bankers are not the only ones we should look at in a new light. Another casualty of the crisis should be belief in the powers and virtues of government regulators, because their fingerprints are all over the crime scene as well.

There are 39,000 individuals working full time to regulate the financial markets in the U.S. alone. What did they do when the bubble was inflated? Well, they helped inflate it.

In the 1970s and 1980s, we learned that regulation of product markets caused many problems. The public choice school taught us that when regulators have to choose between increasing their powers and budgets and what improves society, they often choose the latter. Even well-meaning regulation often produces unintended consequences that turn small problems into big ones.

But when the financial markets seemed to be doing reasonably well, that criticism never really had an impact on the world of finance.

What a difference a crisis makes! A detailed anatomy of the bubble shows that many of the policies and regulations meant to reduce financial risk actually increased it. The most obvious example is the government's policy of bailing out financial institutions to avoid crises, which made it more likely that they will engage in risky behavior. And the Fed's attempt to abolish recessions with drastic reductions of the interest rate it sets resulted in the biggest credit bubble in history, and one of the worst recessions.

But there are several other examples in this crisis. In the 1970s, the SEC gave the big rating agencies a regulatory role. They got the right to officially define risk, and other investors were forced to abide by them; many funds were not allowed to invest in anything that was not considered investment grade, and other institutions were forced to hold more capital if they did.

This oligopoly was granted in order to control risk. But the institutions used their new role to inflate the ratings, and dangerous mortgage-backed securities were suddenly considered risk-free. The deal would get the same generous treatment even if it was structured by cows, as an analyst at a big rating firm said in an internal discussion. Since the cows paid well, and the market was forced to follow the ratings anyway, why not?

The banks did not hold these securities in a transparent way, but in the opaque "shadow banking sector, " in an attempt to reduce risk. The smartest bank regulators in the industrialized world met for six years to produce the Basel agreements on capital requirements for banks. Their requirements made it expensive for banks to hold assets - like mortgage-backed securities - on their balance sheets, but very profitable to put them in non-transparent conduits or vehicles financed by short-term loans on the market.

So even if the best and the brightest introduce regulation because they think it is in mankind's best interest, there are unintended consequences. Indeed, bureaucracies and governmental authorities also have their own agendas and their own interests, and sometimes that trumps social welfare. One reason why financial regulators did not notice what was going on was that they were engaged in turf war. One former SEC commissioner admitted that his agency failed to develop open marketplaces for mortgage-backed securities because it was "distracted." The object of its time and resources: grabbing power from other government agencies by starting to regulate hedge funds and introduce new types of supervision of mutual funds.

We need to take another look at regulation. The world is a complex place, and often progress is made by trial and error. Introducing a standard means confining everybody to the present knowledge of the bureaucrats, and preventing individuals and businesses from adapting to new information as it is discovered. This cannot be avoided in every instance, but it is important to always evaluate it critically and to keep unregulated parts of the economy unregulated so that we don't put all of our eggs in one basket.

The unregulated hedge funds were still standing and supplied the economy with liquidity when everything else failed last September, partly because they were not subject to the same capital requirements as other sectors. If the attempts to regulate them now were to succeed, we would give all financial actors the same Achilles' heal. It might not be likely that this is the heel that will be hit the next time, but if it is, everybody falls at the same time.

Do not expect too much from new regulations. Tomorrow's crisis is often a result of the solution to the last crisis.

The narrative in Washington is that competition among financial regulators allowed financial institutions to choose the weakest regulator, and also encouraged regulators to weaken their supervision and enforcement in order to attract more entities toward their charter. This drives the call by Democrat congressional leaders and the Obama administration for the elimination of both the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), and their merger into a single "super" bank regulator.

But is this narrative more than mere assertion? Fannie Mae and Freddie Mac could not choose their regulator, nor could Bear Stearns or Lehman Brothers. The worst-performing U.S. institutions at the very center of the crisis had no choice in their regulator.

And of course, this was not simply a U.S. crisis. Northern Rock had no ability to choose its regulator. The U.K., like much of the world, does not have multiple bank supervisors, but only a single supervisor. In fact, only three developed countries have multiple bank supervisors: the United States, Germany and Liechtenstein. And only in the U.S. is there any real degree of competition between bank regulators. If this were a crisis driven by competition among bank regulators, then most of the world would have been spared.

Why then merge the OTS and the OCC? Apparently the proposal rests upon the observation that both AIG and Countrywide owned thrifts at the time of their failure. In addition, the failure of thrift IndyMac was one of the largest bank failures to date. Not long after came the failure of Washington Mutual (WaMu). Therefore, the OTS must have been the weak link.

However, both AIG and Countrywide acquired federally chartered thrifts late in the game; their failures were already "baked in the cake" long before they acquired thrifts. Their thrift subsidiaries were also very small parts of their balance sheets. And in neither case did their failure result from their thrift subsidiaries.

In relation to IndyMac and WaMu, the entities regulated by the OTS specialize in mortgage finance; hence it should not be surprising that in the aftermath of a housing bubble, those engaging in mortgage finance fail at a greater rate. More importantly, neither the failure of IndyMac or WaMu cost the taxpayer a dime. The market disruption from their failures was minimal.

Prior to the savings and loan crisis, when there really was a significant difference between bank and thrift charters, thrifts could not choose to maintain their current business model and also flip charters, yet that lack of regulatory competition did nothing to help avoid the S&L crisis.

The competition that does occur among bank regulators is the result of our dual state-federal banking system. However, Obama's proposal includes no mention of changing that dual system.

The real desire for consolidation is revealed in Secretary Geithner's regular attempts to silence the independent bank regulators. The different perspectives of Sheila Bair, John Dugan, John Bowman and Ben Bernanke have offered valuable insights into the regulatory debate. Silencing these voices will not help avert the next crisis, nor will it improve the quality of current reform efforts. Creating a single bank regulator, under the supervision of the Treasury secretary, would deprive Congress and the public of much needed diversity in views on bank regulation.

To the extent that concerns about charter shopping are valid, there is an easier and more effective fix than merging regulators: Require the FDIC to base deposit insurance premiums on the historical and expected losses by charter. One could also require the FDIC to base premiums upon the location of the bank as well. There's no reason for the rest of the country to subsidize the risky behavior of California-based mortgage lenders.

The administration should abandon its knee-jerk ideological opposition to competition and recognize that in many parts of our financial system, such as with Fannie and Freddie or with the credit rating agencies — it was the lack of competition, not its abundance, which contributed to the crisis.