You could be forgiven for not having heard of Brooksley Born, the elegantly named lawyer who chaired the obscure Commodity Futures Trading Commission during the Clinton administration. It was ten years ago this month that Born had a memorable showdown in an ornate Treasury Department conference room with two demigods of contemporary American capitalism, Robert Rubin and Alan Greenspan.

At issue was Born's plan to explore the possibility of regulating over-the-counter derivatives, a financial instrument used to spread risk whose popularity had soared during the '90s. Rubin and Greenspan would have none of it--they objected even to the notion of thinking about greater regulation of derivatives, which were not (and still aren't) subject to the same basic rules that apply to other securities like stocks and bonds. "If somebody says to me, 'I'm contemplating punching you in the nose,' I don't presume that is a wholly neutral statement," Greenspan complained.

It's not surprising that an Ayn Rand disciple like Greenspan considers even modest regulation of financial markets akin to physical assault. What is surprising is how readily the Clinton administration concurred. Born lost the debate and quietly left the administration in 1999. But it wasn't long before her view was vindicated: The lack of regulation in the derivatives market helped fuel the panic caused by the 1998 implosion of Long-Term Capital Management, a major hedge fund.

In recent weeks, liberal-minded wonks have gnashed their teeth over the various regulatory failures that led to the current subprime meltdown. And there's no question that the deregulatory efforts of the last ten-to-twelve years played a role. The formal repeal of Glass-Steagall--the New Deal-era restriction on mergers between commercial banks, investment banks, and insurance companies--in 1999 helped clear the way for financial giants like Citigroup to buy and sell now-notorious assets like mortgage-backed securities. But the truth is that the connection between specific deregulatory efforts and the current crisis, while real, is murky and indirect. By the time Congress had wiped Glass-Steagall from the books, it had spent more than two decades pecking away at such restrictions. Mergers between commercial and investment banks had become commonplace.

The far bigger problem of the last decade has been the symbolic message Washington sent to the financial markets. On the one hand, as the Born episode illustrates, the roaring '90s ushered in a bipartisan belief that Wall Street could do no wrong--that it was offensive to even consider substituting the knowledge of small-minded bureaucrats for the towering wisdom of traders and their abstruse risk models. At the same time, the government signaled that when, by some freak alignment of the stars, the traders erred and their models broke down, Washington would be there to clean up the mess. How else to interpret the Long-Term Capital bailout scrupulously engineered by the New York Fed with the blessing of Greenspan and the Treasury Department?

So it's curious, if not surprising, that Washington has responded to the current crisis by doubling down on this same message. The plan Treasury Secretary Henry Paulson announced this week isn't a complete disaster. There are a handful of worthy details--most notably the creation of a federal Mortgage Origination Commission to develop minimum licensing standards for mortgage lenders--that Congress should enact.

It's the broad thrust of Paulson's proposal that's utterly mystifying: The Fed would receive enhanced authority to intervene in the trading activities of investment banks--it would formally gain the power to give Wall Street banks the full Bear Stearns treatment. But that authority would only relate to activities that posed "systemic risk"--which is to say, the risk of a market meltdown. For activities that didn't clear that threshold, the Paulson plan would actually reduce federal oversight in some respects--for example, by giving stock exchanges a larger role in regulating themselves and expediting approval of new financial products.

Unfortunately, it's rarely obvious which activities will lead to a meltdown before we're on the verge of one. If the problem with the current regime is that it encourages reckless behavior, Paulson's response is to encourage even more of it. Under the current regime, Wall Street traders have little supervision when they gamble huge amounts of borrowed money on bets they only vaguely understand. What they do have is a sneaking suspicion they'll be bailed out if the bets turn bad. Under Paulson's proposal, the Wall Street traders could end up with even less supervision but more confidence in a forthcoming bailout.

This is no longer just moral hazard; it's moral stupidity. With all due respect to Greenspan, Brooksley Born wasn't angling to punch anyone in the nose. But, by this point, it might be a good place to start.

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