Changing the Rules

AT THE best of times, economic regulation does not lend itself to close examination in election campaigns. Regulation, like economics itself, is about trade-offs and judgment, whereas candidates need to put things in black and white.

That is even more so in this election, when Barack Obama and John McCain are being forced to respond to events that trained economists and bankers barely understand: a housing crash linked to mind-numbing financial instruments, a brush fire of insolvency among financial firms, and a proposed $700 billion bail-out on unclear terms.

The two men's divergent philosophies on the role of regulation, government intervention, and free trade offer important clues as to what they would like the world to look like when the dust settles. These, at heart, are different aspects of one central question: just how free should the free market be? Since Mr. McCain has always been on the side of free markets and this crisis has often been blamed on the excesses of unbridled capitalism, Mr. Obama has had the chance to seize an advantage.

The core of the crisis that has engulfed the final weeks of the campaign is that falling prices of property and other assets are turning the loans used to finance them bad. These loan losses erode the capital of financial institutions, making some fail and others wary of lending. In theory, this cycle should end once property prices fall to a level that entices a fresh wave of buyers. But a lot of damage can be done in the meantime, as the withdrawal of credit leads to more economic weakness and so to even lower asset prices, which may eventually fall below even bargain levels.

The Great Depression in the 1930s and the American, Scandinavian, and Japanese banking crises of the 1990s eventually required the government to take over many failing institutions to remove bad debts from the system. So how much more could and should the federal government be doing?

The Federal Reserve's bail-out of Bear Stearns and the Bush administration's takeover of Fannie Mae, Freddie Mac, and the insurance group AIG were reluctant steps to stem the damage; the line was drawn at saving Lehman Brothers. But the Bush administration’s latest plan for stabilising the markets, a $700 billion buy-out of bad debt from struggling banks, is a much bigger proposition. While the two candidates’ utterances on such actions change with the flow of events, at heart their positions come down to how much public money they think should be committed to getting out of it, who should get it, and who else should benefit.

Mr. Obama and Mr. McCain have both said taxpayers' money should not be used to bail out the firms and executives whose behaviour sparked the crisis. But Mr. McCain, like most Republicans, has generally been the more hostile. He praised the Treasury for not using public money to prevent Lehman's bankruptcy. But he has also chopped and changed. Initially he opposed a bail-out of AIG, then supported it after the fact. On September 18th he called for the creation of a “mortgage and financial institutions trust” to prevent weak institutions from becoming insolvent. He then attacked the administration's plan.

Mr. Obama has been more neutral on the bail-outs. He says that he wants any assistance for Wall Street firms to be paired with “equally swift and serious” help for the struggling families of Main Street, and that any rescue plan for banks must be temporary.

Their differences were already apparent earlier this year, when Mr. Obama strongly backed a Democratic proposal to commit up to $300 billion to restructuring the mortgages of troubled homeowners. Mr. McCain proposed a smaller plan. "It is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers," he said in March. He eventually dropped his opposition to the larger plan, as the Bush administration did.

These opposite starting positions will matter if the crisis gets ever worse. The sooner government intervention occurs, the more effective and, in the end, cheaper it is likely to be. But intervention that proves unnecessary creates moral hazard and big liabilities.

Mr. Obama has addressed the crisis earlier and in more detail than Mr. McCain. He has laid the lion’s share of blame on unscrupulous lenders, mortgage-industry lobbyists and inadequate oversight of credit-rating agencies and financial institutions, and was writing letters to this effect more than a year ago. He has made it clear that, if elected, he would regulate Wall Street more tightly, both with stiffer capital requirements and closer oversight, especially of firms that borrow from the Federal Reserve. He would streamline the country's many regulatory agencies and create "a financial market oversight commission" to anticipate future crises.

In the Senate, Mr. McCain has never played a leading role in financial issues, but his instincts have always been against more regulation. He told the Wall Street Journal in March that although the subprime crisis revealed a role for oversight, "I am fundamentally a deregulator." He has tended, more than Mr. Obama, to blame the crisis on an impersonal housing bubble, rather than on flesh-and-blood financiers.

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