Paul Krugman has attacked Senator Evan Bayh‘s suggestion that the Obama administration “overreached by focusing on health care rather than job creation during a severe recession.” Krugman expresses great difficulty in seeing what this statement could mean.

Are people who say that Mr. Obama should have focused on the economy saying that he should have pursued a bigger stimulus package? Are they saying that he should have taken a tougher line with the banks? If not, what are they saying? That he should have walked around with furrowed brow muttering, “I’m focused, I’m focused”?

To answer Paul Krugman’s question, let me suggest that the severity of the current recession could have been reduced if the Obama administration had made financial regulatory reform its top legislative priority in 2009.

When President Obama was inaugurated in January 2009, the American economy was sliding into recession because of a catastrophic loss of confidence in our financial system. In the previous decade, global investors’ confidence in American financial institutions had brought vast capital inflows into the American economy. This confidence had been based on a perception that America’s legal and political system provided safeguards for investors that were second to none in the world. This confidence was shattered in 2008 with the collapse of Lehman Brothers.

A meaningful and effective financial regulatory reform in 2009 could have restored investors’ confidence, reviving investment flows and stemming the loss of jobs. Imagine how different the economic environment might have been on election day in 2010 if President Obama could have announced by September 2009 that, after an intensive review of the financial regulatory system by both Congress and the White House, he was signing into law some carefully designed and well-focused reforms that could restore investors’ and taxpayers’ confidence in American financial institutions.

The focus on health care reform made it impossible to achieve meaningful financial regulatory reform for more than a year after President Obama took office. Health care reform and financial regulatory reform are both extremely complex issues and both have been fiercely resisted by powerful vested interests. Neither reform could be accomplished without strong political leadership at the highest level. The Obama administration could only address one at a time, and only one could be the central focus in the crucial first year when the new President’s political capital was greatest. The Obama administration chose in 2009 to focus on health care reform.

It may be surprising that, when a catastrophic macroeconomic decline is clearly being caused by a loss of confidence in the basic regulatory controls of our financial system, that many leading economists would not see financial regulatory reform as an urgently needed remedy. The reasons may also be found in the history of economic theory, on which I may comment later.

[Thanks to Jeff and Sandeep for letting me guest-blog here.]