June 19 (Bloomberg) -- President Barack Obama doesn’t need to just overhaul financial regulation. He needs to exorcise the ghost of Alan Greenspan.

For far too long, regulators weren’t willing to regulate, inspired by the view of the former Federal Reserve chairman that too much oversight is a greater threat to markets than too little. That turned out to be a bigger cause of the credit crisis than the particular structure of the agencies overseeing the financial system.

Donald Kohn, the Fed’s vice chairman, summed up the prevailing regulatory attitude in 2005, saying, “The actions of private parties to protect themselves -- what chairman Greenspan has called private regulation -- are generally quite effective,” while government regulation risks undermining “financial stability itself.”

Unless Obama can change that mindset, which is entrenched in many of the institutions overseeing banks and markets, the details of his 88-page reform plan won’t matter much.

And while there appears to be a newfound appreciation for government oversight, we can’t be certain yet about the intentions of those shaping the Obama plan. Some of them, after all, were one-time advocates of Greenspan’s views, or at least failed to challenge them.

Greenspan’s Disciples

Treasury Secretary Timothy Geithner, one of the architects of the Obama overhaul, was a big promoter of the kind of so- called financial innovation that ultimately helped bring about the crisis.

During a speech in early 2007, Geithner argued that innovative products such as credit default swaps and collateralized debt obligations “should help make markets both more efficient and more resilient.”

And Geithner, at least back then, echoed Greenspan’s belief that regulators shouldn’t try to stop bubbles from forming. In the same speech, the then-chief executive of the Federal Reserve Bank of New York also said, “We cannot identify the likely sources of future stress to the system and act preemptively to diffuse them.”

Geithner wasn’t alone in espousing Greenspan’s hands-off approach. His co-pilot on the new Obama plan, National Economic Council Director Lawrence Summers, held similar views.

Summers aligned with Greenspan to kill off attempts to regulate derivatives markets when he worked in Bill Clinton’s administration. That deprived regulators of influence over a key and fast-growing market, an area in which risks to financial institutions would fester.

Regulatory Tension

In unveiling his regulatory plan Wednesday, Obama noted that there is always tension between those who favor the market’s “invisible hand” and those who favor “the guiding hand of government.”

He rightly added that such tension isn’t always a bad thing. Yet in recent years, the invisible hand ruled.

Under Greenspan’s laissez-faire approach, markets would police themselves and risk would be spread far and wide. The theory was that losses would be more easily absorbed if a broad base of investors, rather than a few banks, held risk.

Even as cracks began to gape in the financial system in early 2007, Geithner continued to hew to this view. While acknowledging in his speech at the time that problems with subprime mortgages may signal a gathering storm, he said that credit-market innovations should help ease any pain: “If risk is spread more broadly, shocks should be absorbed with less trauma.”

Hidden Risks

It didn’t work out that way. Rather than dispersing risk, many of the policies espoused during the Greenspan era simply caused risks to regroup out of investors’ and regulators’ sight.

This meant that investors couldn’t know who was holding what types of assets, which ultimately led them to stop trading with one another. Credit markets began to freeze.

Greenspan and his followers also trumpeted financial engineering, hailing the creation of exotic securities that would supposedly help to disperse risk. In the end, much of the innovation -- like structured investment vehicles or CDOs -- proved ephemeral.

Even those who weren’t Greenspan disciples, such as Fed Chairman Ben Bernanke, failed to challenge the prevailing orthodoxy. Bernanke has been reluctant to abandon the financial- innovation theme promoted by his predecessor.

In a speech this April, Bernanke acknowledged that financial innovation is currently “perceived as the problem.” That said, the Fed chairman rose to its defense, saying that, “Innovation, at its best, has been and will continue to be a tool for making our financial system more efficient and more inclusive.”

Given that so many regulators and political leaders sipped from the Greenspan Kool-Aid cup, it will take time to see if the financial crisis has sobered them up.

If not, Obama can play with regulatory organizational charts all he wants, and it won’t make much difference.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net

Last Updated: June 19, 2009 00:02 EDT