Guest writer Nicole Gelinas is a contributing editor to the Manhattan Institute's City Journal, and author of After The Fall: Saving Capitalism From Wall Street -- and Washington.

The debate over the Volcker Rule, President Obama's proposal to force commercial-bank holding companies to shed hedge funds and prop-trading arms, shows that Washington is far from understanding the meltdown. The news that financial regulation is at an impasse, then, isn't so bad -- for how can Congress fix what it doesn't get?

The idea behind the Volcker Rule, as former Fed Chairman Paul Volcker told the committee last Tuesday, is that "commercial banks have an essential function in the economy, and that is why they are protected. But we don't have to protect more speculative activity."

But speculation is credit creation. The line between the two began to blur two decades ago as credit moved to the capital markets.

Which firm is doing "essential" banking? A small commercial bank that makes a mortgage and keeps the loan on the books, or a big-city investment firm that flips the mortgage on a prop-trading desk to make an interest rate profit?

Both are doing the same thing: supplying credit.

Volcker helped in this convergence, via a circuitous route
In 1984, Washington created the first "too big to fail" commercial bank, Chicago's Continental Illinois. With Volcker at the Fed's helm, the Reagan administration feared that the economy couldn't withstand Continental's failure, because the bank's reliance on short-term debt markets could cause disruption.

Washington stepped in and guaranteed all of Continental's creditors, not just insured depositors -- a watershed.

Volcker went before Congress and said that the decision was not a precedent. But markets knew otherwise. Commercial banks used their implicit government backing to compete with the lucrative securities world on its own turf -- and the investment world responded with its own weapon: capital-markets creativity.

By 2006, nearly 48% of household and business debt came through securitized debt, up from one-third of debt outstanding in 2000.

Soon, we learned what would happen if these markets staged a run. Starting in 2007, global investors dumped their AAA-rated securities, killing credit supply -- and killing the economy's demand for labor. The social cost of uncontrolled markets "working" was unacceptable -- just as it was in the 1930s at the old-fashioned banks.

The experience illustrates that what we learned in the '30s is still true. Washington must insulate the economy's vital stores of credit from inevitable financial-markets exuberance and panic.

Then and now
Eight decades ago, this task was easy. Banks were where the credit was -- so, regulate the banks. Congress created the FDIC, protecting small depositors so that banks could fail -- and benefit from market discipline -- without causing credit-destroying contagion.

Congress also forced banks to sell their securities businesses, so that the long-term loans that they held on their books -- the nation's credit -- would have some buffer against capital markets' acute optimism and pessimism.

As for the "speculative" securities markets: Congress' fix was to let securities firms and investors do what they wanted. The catch was that they could do so only within consistent borrowing limits, as well as trading and disclosure rules. They could blow themselves up without blowing up the economy with unpaid debt and hidden risks.

The separate-and-regulate strategy won't work today, unless Washington bans debt securitization and trading.

Volcker implicitly admits as much. He hasn't asked Congress to prohibit commercial-bank holding companies such as Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase (NYSE:JPM) from underwriting or buying securities.

Debt securities have become too important for anyone to suggest a ban, or even, as government-support programs like TALF show, for the securities to disappear by themselves without extraordinary government support.

Congress can see that the Volcker Rule wouldn't work -- but it can't understand why. In the hearing, committee chairman Sen. Chris Dodd (D-Conn.) hinted at regulators' likely inability to differentiate between allowable "bank hedging behavior" and prohibited "profit-making trades."

But he skipped over the impossibility of distinguishing between essential credit that needs a government safety net and fun-and-profit credit that, Volcker says, doesn't.

Sen. Mike Johanns (R-Neb.) got Volcker to admit that the rule "certainly would not have solved the problem at AIG (NYSE:AIG)" nor at Lehman Brothers. "It was not designed to solve those particular problems," Volcker said.

But nobody seemed to understand why the economy needs protection from the panic that radiates from firms such as AIG.

The Senator who came closest was Chuck Schumer (D-NY). "We've securitized everything," he mused. "Everything got securitized. Credit card loans got securitized" and sold off to the markets.

"Whatever the place in Greenwich ... wasn't that large a company, but if the Fed didn't intervene ... we might have had the whole system unravel," Schumer concluded, referring to the 1998 rescue of the Long-Term Capital Management hedge fund.

Indeed, LTCM's uncontrolled failure could have precipitated a 2008-style "credit crunch" -- as nobody would have wanted to touch any debt security amid sell-offs and plummeting prices.

The question, then, is: How do we protect the economy from old-fashioned bank runs in the new-fangled credit world, without arbitrary bailouts that obliterate market discipline?

Washington must revisit the '30s-style rules for the old securities markets, not the banking side -- and apply them to new the modern debt-securities markets.

Solving "too big to fail"
One rule is consistent government limits on borrowing -- notwithstanding the perceived risk. Back in the 1930s, the feds didn't direct regulators to say, "OK, Woolworth stock is safe, so you can borrow 90% against that. RCA stock, not so safe, so you can only borrow 10%." The rule was across the board.

This time around, the government should similarly force financial firms -- from commercial banks to hedge funds -- to hold a consistent percentage of hefty capital behind all securitized debt, rather than giving some firms a break on AAA-rated securities and some firms a pass completely.

Such a rule would have slowed credit creation -- muting the bubble and the crash. Just as important, the economy would not have been so vulnerable to the government's top-down catastrophic mistake in assessing securities' risk.

The economy would not have been so vulnerable, either, to the government's similar mistake in deciding which financial firms are "essential" to credit supplies and which aren't.

A second necessary measure is consistent rules on trading and clearing. If AIG had had to put down $10 billion up front on a $100 billion derivatives liability, for example, and place the cash on reserve at a clearinghouse that had collected other counterparties' monies for the same purpose, markets would have known that some money existed to absorb losses.

Investors would have known, too, where the residual risk lay, and wouldn't have begun to pull from the entire system.

The difference between regulated and unregulated derivatives is why Barings (later bought by ING (NYSE:ING)) could fail in 1995 without destroying the world's credit, but three years later, the Fed wouldn't take the risk with LTCM.

A third necessary rule is a capital charge for short-term borrowing. Banks and non-bank financial companies that rely on short-term markets inject an extra potential for market panic into the economy. It doesn't matter whether they have mostly long-term assets. When a firm's lending can dry up overnight, everything is mark-to-market.

If Congress enacts these three rules, it will have also solved "too big to fail." Lenders will know that financial firms can't hold the economy hostage by holding its credit supplies hostage -- renewing the most important regulation, market discipline.

Moreover, the rules would solve the "too big to fail" problem at commercial banks. Volcker confuses Congress when he implies that access to a limited public-safety net for commercial banks is a get-of-jail free card. Until the 1980s, it wasn't.

If commercial banks can't fail, no Volcker Rule, or any other rule, will rein them in. Their lenders will continue to lend without surveillance, and capital-markets firms will continue to unleash their weapon -- creativity -- in response.