Can D.C. fix what ails the system?

WASHINGTON â€”  Lost amid last week’s bad economic news, an unexpectedly partisan vote on the stimulus and President Obama’s saber-rattling over Wall Street bonuses were the opening shots of a battle over how far Washington should go to reshape the financial system.

But the clash won’t remain in the shadows for long.

The administration is under mounting pressure to deploy hundreds of billions -- perhaps trillions -- of new dollars to shore up financial firms into which the government has already poured a fortune. Analysts say the only way to make such a politically unpopular step palatable is for the new president to explain what he’ll do to ensure the problem never happens again.

That means a return to the kind of regulatory system that Wall Street and economic conservatives fought to dismantle going back to Ronald Reagan’s presidency and continuing through that of George W. Bush -- or something even more stringent.

Nor is the fight likely to remain confined to finance.

In laying out its plan for revamping the money business, analysts say, the administration will offer the first hints of how aggressively it is prepared to intervene in other damaged or seemingly dysfunctional sectors of the economy such as housing, healthcare, autos and energy.

“The battle is joined between those who say that the reason for the current crisis is insufficient government regulation and those who say that the cause was excessive government involvement in the economy,� said Peter J. Wallison, a fellow with the conservative American Enterprise Institute and an architect of the Reagan administration’s deregulation drive.

The condition of the nation’s big financial institutions and the question of whether many are sinking into a new round of trouble have been the sleeper issues in the administration’s early weeks.

While Obama has sought to train public attention on his plan for jolting the economy back to growth with an $800-billion-plus stimulus plan -- a version of which passed the House last week -- Federal Reserve Chairman Ben S. Bernanke and others have warned that the financial system may be taking another turn for the worse and require another expensive fix.

Newly installed Treasury Secretary Timothy F. Geithner is expected to outline the administration’s proposed fix in a matter of weeks, if not sooner.

When he does, the package will almost certainly include billions of dollars for homeowners struggling with sinking house values and rising mortgage payments. And it will try again to stabilize shaky financial institutions, either by creating a federally financed “bad bank� to assume firms’ troubled assets, by agreeing to bear many losses the firms now bear alone or by seizing financial companies to run or shut down.

The package could signal where the administration is headed on restructuring the system to prevent a repetition of the current mess.

Asked about a sweeping restructuring Wednesday, Geithner appeared to discount the prospects. “We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system,� he said.

But by Thursday, fresh pressures had begun to make themselves felt. Democratic and Republican appointees to a congressionally created panel overseeing the government’s $700-billion financial bailout issued drastically different accounts of what needed to be done to keep the nation’s banks and markets from veering off course in the future.

On one side, the Democratic majority, led by Harvard University bankruptcy expert Elizabeth Warren, called for new regulatory structures as sweeping as any since the Great Depression. The framework would be likely to transform how Wall Street does business.

“It’s not enough to regulate only when things fail,� Warren’s report said. “Left to their own, financial markets boom and bust. They chase themselves up and back down again,� threatening substantial economic damage in the process.

“That’s why we make the affirmative case for continuous regulation.�

On the other side, the group’s GOP minority suggested that about all that’s needed are stricter standards for mortgages and streamlining existing agencies. It strongly implied that the country’s financial problems stem mainly from too much, not too little, regulation.

“In a number of important cases, government policies that have unintended consequences have created problems rather than solved them,� said former Sen. John E. Sununu of New Hampshire.

The majority’s key proposal tackles the nettlesome problem of “too big to fail.�

Policymakers have long worried that some financial firms had grown so large that the government would be forced to help them in case of trouble or risk seeing the entire system pulled down too.

Policymakers learned during the last 18 months that there are many more such firms than they’d imagined.

The problem with a “too big to fail� firm is that the company enjoys an implicit guarantee in advance of any crisis, one it doesn’t pay for. That allows it to operate with a kind of impunity, knowing Washington will ride to the rescue if it gets into trouble. The assumption also lulls investors into a false sense of security.

“Implicit guarantees may well be the worst kind of government guarantee,� said Harvard economic historian David A. Moss, on whose work much of the Democratic proposal was based. “They are ill-defined, open-ended and almost impossible to get rid of.�

The Democratic panelists’ solution: Have Washington sort financial firms into those that have “systemic significance� and those that don’t. The first group would face much stricter regulations, such as requirements that they maintain larger capital cushions in case of trouble, limits on the business they can do with borrowed funds and perhaps even payment of premiums to the government for “capital insurance.�

“Right now, we have lots of implicit guarantees. We say, ‘We’ll guarantee you, but we won’t regulate you,’ � Warren said. The panel majority, she said, proposes that “we make those implicit guarantees explicit.�

In calling for the changes, the majority cited work by Moss showing that strict regulation during the half-century between the New Deal and the Reagan revolution produced an era with few financial failures, but loose regulation both before and after resulted in many more failures and a string of financial panics.

Singling out “systemically significant� firms and imposing stricter regulations would alter the financial terrain and, perhaps, transform such giants as Goldman, Sachs & Co. and JPMorgan Chase & Co. from innovative powerhouses into much more controlled and subdued operations.

In a portent of the arguments that will be made against ratcheting up regulation, the panel’s two Republicans, Sununu and Rep. Jeb Hensarling of Texas, issued a lengthy counter to the majority’s report, arguing that it was government rules, not the actions of business, that caused the current crisis.

The pair accept the need for a government bailout to address the crisis and endorse modest new rules to prevent similar calamities in the future. But they train most of their attention on Fannie Mae and Freddie Mac, the failed government-created mortgage giants.

Sununu and Hensarling argued that the two firms so distorted the housing market that they made a financial breakdown inevitable. Relying on the work of Wallison, the Reagan-era deregulator, the two men use Fannie and Freddie as evidence that Washington, not Wall Street, is the villain in the drama.

“The current crisis was caused by excessive government involvement in the economy, and the way to address it is to get the government out,� Wallison said. The Democrats, he complained, want to head in the opposite direction.

Last week, it was dueling reports. But when the Obama administration begins to unveil its big-picture plan for setting the economy aright, the battle over regulation will break out on a wide front.

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