Does Big Government Need to Rescue Big Money?

Remember how back after the tech-stock implosion in 2000, Congress passed all those new laws and regulations to prevent companies with fanciful business models and completely unrealistic profit projections from going public? You don't? Well, that's because it didn't happen. It didn't have to.

The market—meaning investors—finally smartened up and wanted no part of any future pets.coms. This is something to keep in mind as new rules are proposed to govern America's financial system. The marketplace has already begun the transformation process. Just take a look at these factoids from a new report on the financial industry from Morgan Stanley and consulting firm Olive Wyman (via Bloomberg):

1) Revenue from investment banking may drop 20 percent as banks take another $75 billion in markdowns this year.

2) Bank revenue from their credit businesses may drop as much as 60 percent.

3) The financial crisis may last for eight to 10 quarters, exceeding the six-quarter duration of the Asia crisis and bailout of [Long Term Capital Management] in 1997-8, and the seven-quarter fallout from the bursting of the dot-com bubble.

4) Writedowns and losses on subprime-infected assets have already cost the world's biggest financial institutions about $230 billion since the start of 2007.

The report's conclusion: "Firms with diverse sources of funding, with retail and commercial deposits clearly helping, and a diversified business will have a funding advantage over the coming years. This may lead to a material reassessment of business models over time."

Just as with the bursting of the tech bubble, the marketplace responds. As it is, Treasury Secretary Hank Paulson's reform plan isn't going anywhere this year, though it does lay down a policy marker. Democrats are already ripping it, saying that the plan to reorder federal regulators—including making the Federal Reserve a financial "supercop—fails to give them any additional enforcement authority.

But even if there were more regulatory bite in the Paulson plan, to what ultimate end? To prevent future bubbles or the next big financial crisis? Wow, that would have to be some plan. Consider what economist Martin Feldstein told the WSJ: "Supervising the very complex derivative products of the banks and of the rest of the financial system would be an enormous technical challenge. The institutions themselves—paying very high salaries and having their own survival at risk—got it wrong. Would the Fed get it right?"

Capitalism is messy. Without loss, there can be no gain. Without risk, no reward. And the less the chances of the former, the less the chances of the latter. Whatever system is in place, humans will try to game it for profit. That's what we do—unless government hammers us so hard there is no chance for profit.

We also tend to go to the extremes, as the behavioral scientists tell us. And it doesn't make much difference if you are an average investor or a Wall Street big shot—especially when interest rates are superlow or tech stocks superhigh.