What's the Biggest Flaw in the Administration Bailout Plan?

The biggest flaw in the Administration bailout package: It could all happen again. The system doesn’t need just fixing, it needs decentralizing. Financial institutions should be big enough to fail—and never any bigger. We need compartmentalization, also known as federalism.
The current crisis was caused by mega-financial institutions that could gamble their money—and lose it. And they did. But first, they grew to the point where they couldn’t be allowed to fail. That’s why even a staunch free-marketeer such as Larry Kudlow supported the AIG bailout. “A collapse of AIG would have been unfathomable,” he wrote on Saturday. “It is simply too interconnected globally."

Well OK, then, AIG was too big. When even free-marketeers want the government to step in, that’s proof that size matters. In a bad way. But the American people cannot let themselves be hostage to the financial megalomania of casino-capitalist empire builders.

It might, indeed, be the responsible thing to vote for a bailout, but it is irresponsible to allow such a meltdown to happen again. And it will happen again if banks, investment houses, and insurance companies are allowed to grow this big once again. Adding another layer of regulations and record-keeping will make work for more lawyers and more accountants, but if the basic business model survives—gambling with other people’s money, and lots of it—then we will right back into deep doodoo soon enough, except that the dollar totals will have a few more zeroes. Remember Sarbanes-Oxley? What good did that do?

As my colleagues at the New America Foundation, Sherle Schwenninger and Michael Lind, have argued for years, we need different kinds of banks to do different things. So the Depression-era Glass-Steagall Act—which solved this problem once before—should be restored, so that the bank down the street once again is limited to only accepting deposits from its neighborhood and only making loans to locals. That’s a boring low-margin business, to be sure, but it’s mostly a safe business. Meanwhile, on Wall Street, investment bankers and speculators would be free to speculate, but they wouldn’t be free to speculate with the capital base of Main Street.

In addition, the states should reclaim their role as laboratories of democracy—and laboratories of the economy. Leaders of each state should figure out how much money they are losing in this deal—that is, how much of that projected $1 trillion they are “contributing.” Or, to put it another way, how much of an income transfer is the state of New York reaping? How much is Manhattan gaining at the expense of all the rest of us?

Politicians across the 50 states might be tempted to demagogue these wealth-transfer data, but there is the not-so-little concern of avoiding a depression.

Instead, politicians should say, “I will vote for this bailout, AND I will also insist that we compartmentalize, or federalize, the solution. How? We should establish a state bank, or a regional bank, to keep capital right here in (fill-in-the-blank) state or region.” If South Carolina and North Dakota keep more of their money in the first place, to be invested in local projects, that will be good news for South Carolinians and North Dakotans. And it will be bad news for money-hungry Manhattanites, plotting their next incomprehensible derivate swap; they will be free to gamble their money, and nobody else’s.

And that would be good news for the rest of us.

This was originally posted on politico.com.

James P. Pinkerton worked in the White House under Presidents Ronald Reagan and George H. W. Bush. Since leaving government in 1993, he has been a columnist for Newsday, a contributor to the Fox News Channel, and a regular on Fox’s Newswatch show.