By William Isaac, Published by Forbes

A failure to understand the lessons of previous crises led to economic collapse.

The panic of 2008 absolutely should not have happened. Its seeds were sown by our failure to understand the lessons of the 1980s and our misguided responses to that crisis. The Senseless Panic of 2008 led to a collapse of the economy and caused enormous pain to millions of people. It must never happen again.

I cannot emphasize enough how important it is that we understand the causes of the financial crisis in 2008 and that we enact the right reforms this time. Those who do not remember and understand history will repeat it.

The S&L crisis was caused by the failure of our political leaders to keep inflation in check during the 1970s, which led to interest rates of a magnitude never before witnessed in this country–interest rates so high that almost no financial institution or borrower could withstand the onslaught. The problems were compounded by the failure of political and industry leaders to reform the S&L charter and bring it into the modern era a decade before the crisis.

A very bad situation turned into a disaster when the Reagan Administration and congressional leaders refused to tackle the problems and instead decided to let S&Ls with poor management and little or no capital grow their way out of their problems. In the five-year period from 1984, when I warned Treasury Secretary Jim Baker of the looming S&L crisis, to 1989, when the first Bush Administration and Congress moved to clean up the S&L mess, the cost of resolution increased nearly 10-fold from an estimated $15 billion to nearly $150 billion (or roughly $450 billion in terms relative to today’s federal budget).

These losses did not need to occur. The FDIC faced up to very similar problems in the savings bank industry, allowing savings banks to get through the very difficult economic times but not allowing them to increase their risk profile. The result was roughly $2 billion of losses to the FDIC and none to taxpayers.

We reacted to the S&L crisis by blaming “greedy” bankers, just as many have done with the crisis of 2008. It is a politically easy target that deflects attention away from the real issues. Someone once said that blaming greed for bank failures is akin to blaming gravity for airplane crashes. Greed, like gravity, is a force of nature. Greed is an important force in our free enterprise system. The government should recognize that greed exists and control it, just as the government recognizes that airplanes will fall from the skies if planes are not properly maintained and operated by skilled professionals.

We reacted to the S&L crisis by declaring that market forces would be more effective in regulating and controlling risks in the financial system than regulators. Compounding the problem of overreliance on market forces to regulate the financial system, our disillusionment with the S&L regulators also moved us to an increased reliance on models and rules rather than judgment and experience.

Market forces and models are useful tools but strong supervision and regulation should always be in the first line of defense in protecting our financial system. Particularly in a crisis, we need to rely heavily on the judgment of trained professionals who are insulated as much as possible from political pressures.

Overreliance on markets and models led the SEC  and its sidekick FASB to put into place the highly procyclical and ultimately very destructive market-to-market accounting system, despite strong warnings from the secretary of the Treasury, the chairman of the Fed and the chairman of FDIC that it would create greater volatility in banking and lead to severe credit crunches.

Reliance on market forces and models led the SEC to challenge the judgmental approach to establishing loan loss reserves and to the creation of procyclical models that understate reserves in good times and overstate them in bad times. The same flawed thinking led bank regulators to create the backward-looking Basel models for setting capital levels in banks. Capital needs are understated in boom years and overstated in difficult times, making it more difficult to restore lending and turn around the economy.

The SEC added fuel by allowing Wall Street firms to greatly increase their leverage in 2005 at the height of the boom. Two years later, just when the bubble was about to burst, the SEC removed the Depression-era protections against abuses by short sellers of securities.

Congress established a highly procyclical method for assessing FDIC premiums. In good times, when the FDIC fund was flush, banks were not required to pay premiums. In times of trouble, banks were hit with very large special assessments, which made it more difficult for them to lend.

Congress enacted statutory Prompt Corrective Action rules that discriminate against smaller banks and make it difficult for regulators to use judgment during times of severe financial distress. Finally, Congress neutered the FDIC’s crisis management abilities by requiring approval from the White House, Treasury, and the Fed before the FDIC can use its emergency powers in times of severe stress.

Businesses, consumers, and the financial system became overleveraged during the decade from 1995 to 2005. Allowing loan securitizations, derivatives, and swaps to be taken off bank balance sheets was an important element in this, as were the procyclical rules on capital and loan loss reserves. Many economists believe monetary policy also played a major role. And there is no question that the uncontrolled growth of Fannie Mae ( FNM – news – people ) and Freddie Mac ( FRE – news – people ) and their movement to riskier mortgage products propelled the housing bubble.

The boom had to come to an end. The markets and policy makers were hoping for a soft landing and for a time it seemed we were going to achieve one. But then the combined effects of the procyclical accounting and regulatory rules took over and turned the hoped-for soft landing into a very turbulent ride. At that point, ineffective crisis management nearly destroyed the financial system and the economy.

Late in 2009, the Obama Administration and the Congress were debating proposals on how to fix the system. Unfortunately, they were moving much faster than warranted, were debating unimportant ancillary issues and were not addressing the issues that really must be addressed.

Because it is such a moving target, there is little point in going into detail on the Administration’s original proposal, which formed the basis for the bill in the House, but I will give a few examples of how far wide of the mark it is:

–It would eliminate industrial loan companies, which had nothing to do with the crisis, but does not deal with Fannie Mae and Freddie Mac, which were at the heart of the crisis and remain wards of the state.

–It proposes an exceedingly minor reorganization of the regulatory structure that failed us in this crisis instead of a clearly warranted sweeping regulatory overhaul.
–It purports to address the problem of too-big-to-fail firms but instead permanently extends the federal safety net and the exposure of taxpayers beyond banking to all companies with financial activities and delegates the authority to accomplish this to regulators so as not to put Congress in the uncomfortable position of actually having to vote to spend our money on future bailouts.

–It proposes a badly needed Systemic Risk Council to monitor developing systemic risks and deal with them before they get out of hand, but instead of making it an independent agency turns it into a handmaiden of the Treasury and the other financial agencies it should be overseeing.

–It does not even mention the procyclical accounting and regulatory rules that played a leading role in creating the panic of 2008.

–It proposes a new bureaucracy in the form of the Consumer Financial Protection Agency to take over the consumer protection functions of the federal banking agencies, which will almost certainly weaken consumer protection for customers of banks and make it more difficult and expensive for consumers and small businesses to obtain loans. There are ways to enhance consumer protections without limiting the ability of banking regulators to use their considerable resources and powers over banks to directly enforce consumer compliance in banks.

One can only hope the bill will undergo significant improvement as it wends its way through Congress. It is distressing that the Administration does not seem to understand what the problems are in our financial system, much less their solutions.