Let the Markets Regulate

Washington’s role in financial markets should be to create a level playing field through proper regulation, not to create unfair advantages through targeted control and support. The Obama administration’s announcement that it will slash and regulate pay at seven bailed-out financial and economic giants, including Citigroup and A.I.G., does the latter, not the former, harming economic recovery.

In a healthy economy, failed private-sector firms go out of business. Bankruptcy allows good assets and workers to escape bad companies. It also enforces market discipline, as it shows shareholders and lenders that reward comes with commensurate risk.

Washington should be working to make large or complex financial firms more accountable to market discipline by creating a way in which big, complex financial institutions can fail in an orderly fashion.

Instead, the targeted “pay czar” approach gives select financial firms even more insulation from market discipline. The marketplace understands that the more intricately entwined the government becomes with these firms, the more the government will support the same firms in the future.

Lenders, then, will continue to offer firms like Citigroup and A.I.G. money at artificially low interest rates, as they did in the years leading up to the credit crunch, when “too big to fail” was already part of the landscape. The firms will continue to have an advantage over other companies and industries, and government-guaranteed failures will crowd out entrepreneurial start-ups.

Taxpayers and citizens can take little comfort that bailed-out financial firms will have a harder time using that advantage to pay oversized salaries and bonuses. The uneven playing field still distorts the economy and handicaps a healthy economic recovery, one that, absent government distortion, likely would support a smaller financial sector.