SAN FRANCISCO – As free-market-loving Americans, we all know overregulating an economy amounts to socialism. We’re now discovering what happens when you underregulate – communism.

The $85 billion federal loan guarantee for insurance giant American International Group is being characterized as a bailout when it’s actually a buyout – with the government taking an 80 percent stake in the world’s 18th largest company. The brutal irony: A conservative GOP administration has essentially nationalized the country’s largest insurer.

Karl Marx’s ghost is dancing on free-market champion Milton Friedman’s grave and Americans are getting a painful economics lesson. To wit: Just as tight regulation puts a choke hold on growth, weak regulation can produce economic catastrophes as it did in Wall Street’s 1929 crash, the savings-and-loan industry’s collapse two decades ago and the calamity now unfolding.

Ever since it entered the English lexicon in 1665, regulation has been a 10-letter word. But since the 1980s, it’s been a four-letter word in the U.S. – one scarcely uttered even by Democrats whose contributions from corporate donors exceeded organized labor’s years ago.

“The premise of regulation is that people need to be saved from their own idiocy,” said University of Chicago finance professor John Cochrane. “It would be lovely if there were a sage angel who could wave a wand that enables us all to make sound financial decisions, but do you think our federal government is capable of doing that?”

Yet regulation is an economic necessity forever undermined by the immovable force of the dominant party in Washington. Democrats tighten, Republicans loosen and the economy is never as nimble or as disciplined as it could be at any given moment because of the after-the-fact nature of regulatory reform and the lag time in the legislative process.

“Regulation is unfortunately reactive,” said Pablo Spiller, an economist and professor of business and technology at the University of California, Berkeley’s Haas School of Business. “The trouble is, regulation cannot foresee innovation.”

And stymieing free enterprise poses the risk of “the baby that’s never been born,” added John Shoven, director of the Stanford Institute for Economic Policy Research . “We don’t want an overregulated economy because the ability to innovate is invaluable.”

Yet a free market is anything but free when taxpayers are left holding the bag for its excesses, and underregulating results in babies not born as well. Consider Microsoft Corp.. The failed federal antitrust case against the software giant has left it dominating the operating-system market, with innovation suffering as a result.

The same drag has occurred with automakers. High gas prices are forcing many Americans to cut back on the quality of meat cuts we buy – if not trimming meat from our dining table entirely – yet Congress pussy-footed around a looming crisis last December in mandating increases in automakers’ average miles-per-gallon requirements by 2020 only 8 miles per gallon higher than the 1987 level.

Not all business execs oppose regulation; many recognize its value. In 1984, DuPont Chairman and Chief Executive Ed Jefferson appealed to Congress to impose regulation on the fledgling “life sciences” industry (later rechristened biotechnology) to allow the company to build research and production facilities without being sued by nearby residents fearing release of Armageddon dust in their backyards.

Why shouldn’t government tell business what it must do when it advances the public interest and curbs excesses? If we can float AIG a loan equivalent to what we spend on the Iraq war in just seven months, can’t we pony up more than a pittance of that amount in federal subsidies for alternative-energy development?

Between now and Nov. 4, John McCain and Barack Obama must address more than the fundamental state of the economy. They must articulate the role government will play in shepherding the world’s leading capitalist economy in the 21st century – however limited or active.

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AP-NY-09-21-08 1706EDT