Now that Congress is well on its way to passing healthcare (or more accurately health insurance) reform it is time for me to return to the topic of financial regulation. My worry is that with the current predilection of our legislators for policy by sound bite we are unlikely to emerge with thoughtful reform.

In my earlier post Towards a New Capitalism (November 2008) I argued that free market capitalism and sound government regulation were not inconsistent goals and that after attending to the primary task of returning the underlying economy to job-creating growth the new administration should undertake a thorough overhaul of financial regulation. Unfortunately there is so much misinformation and superficial thinking coming out of Washington that I fear we will get lots of regulation but little reform. Let me cite some examples.

Last year Senator Grassley introduced an amendment to the TARP legislation that would have barred financial institutions that received TARP funds (whether they asked for those funds or were just ordered to take them) from hiring foreign workers on H-1B visas. This was part of a broader political backlash against immigrants “taking American jobs.” Not only do I find this trend to be dumb public policy but downright un-American.

First from a policy prospective no matter how sympathetic one is about the unemployed 50 year-old autoworker in Detroit he is very unlikely to return to work in place of the 23 year-old Indian math wiz at Goldman Sachs. I believe we should do everything possible to retrain the unemployed provide a decent social safety net (including health insurance) and create real jobs in the economy but ordering banks not to hire the best talent available is not the way to rebuild America. Unfortunately however it makes for good politics and great media sound bites: “I am not going to sit idly by and let taxpayer-supplied bank bailout funds go to replace American workers with foreign temps.” In fact the immigration of talented workers to the US has been a great engine of GDP growth and compared to European nations with falling populations the US economy can be expected to continue to benefit from immigration over the coming years.

Second I think bashing immigrants is counter to the great promise of America. Anyone for “Give me your tired your poor your huddled masses yearning to breathe free”? I recognize that the US has not always been a welcoming shore for immigrants throughout our history but this is our national myth what is “written on the box” what we aspire to. It is a worrying sign that we may have turned to keeping others from sharing the pie rather than working together to increase the size of the pie. A land of “manifest destiny” does not look inwards.

Another worrying example is the diversionary focus in Washington on banker pay. I do not mean to suggest that there have not been some egregious examples of mis-aligned incentives. However for me the key issue was a mispricing and unfair allocation of risk. Quite simply the system permitted the gains to be privatized and the costs to be socialized. Prior to the financial crisis many institutions were effectively overstating the earnings out of which they were paying large bonuses by not sufficiently reflecting the true cost of the risks they were incurring. This was neither illegal nor in violation of applicable accounting standards but led just as surely to outsize profits as if an industrial company under-accrued for future taxes liabilities

Post crisis there is another pay controversy. Many banks made large profits in 2009 on the back of unprecedented government intervention during the crisis and a steep yield curve. Politicians and pundits pointing to an angry public are seeking to ban or tax the potentially large bonuses that may be payable. The UK attempt to tax banks into limiting bonus payments seems to be backfiring per the usual law of unintended consequences and now shareholders are beginning to complain that they will be saddled with lower returns. Again there is a simpler way. Governments have effectively underpriced the value of their 2008 market interventions and thus bank profits are recovering pre-maturely. It is not unusual for bank regulators to encourage banks to recapitalize over time via extraordinary profits (often abetted by inflation) but absent further regulation it should not then be surprising that this will lead to large bonus gains.

The final irony for me is the political pressure that has been applied upon banks around the world to change the form as well as the quantum of compensation. It is no bad thing to require a large proportion of comp to be paid in the form of equity that must be held for three to five years at a minimum. Most public companies already work that way. However it is naïve to think that pay plan design alone will solve all the issues. We should not forget that the “poster child” for banker greed Dick Fuld already complied with exactly what the reformers would like to mandate. He took most of his pay in Lehman stock and went down with a $1 billion loss. If this is not skin in the game then I don’t know what is.

Prudent regulation of financial institutions is necessary because of the important credit intermediation role they play in the modern market economy. But no system of regulation or incentive compensation is self-effectuating. The rules should establish a principled framework in which managers and directors are given the responsibility to act in the best interests of their institutions and held accountable when they fail to live up to those standards. Rather than setting pay limits regulators should focus on fair accurate and transparent accounting standards. If the true long-term costs of various activities were accurately reflected in a bank’s accounts and compensation system there would be no need for “Pay Czars” or windfall taxes.

The American democracy has been prone to cycles of extreme political polarization. It is unfortunate when the climax of one of these cycles coincides with a period in which the nation needs sound policy-making over politics by sound bite.