One of the brilliant things about federalism is the way it prevents states from over-regulating and over-taxing industries by offering firms the ultimate opt-out: exiting for greener pastures, bluer skies and a less intrusive regulatory environment.

Which, of course, is why do-gooders and market-meddlers hate federalism and try to do away with it at every opportunity. The latest comments from Connecticut attorney general and Eliot Spitzer Mini-Me Richard Blumenthal make this all too clear.

As reported in DealBook this afternoon:

“I would certainly prefer that Connecticut has the same rules as every other state instead of having regulation that’s more demanding and could compromise the location of hedge funds here,” said Connecticut Attorney General Richard Blumenthal.

Of course, Blumenthal isn't warning against adopting the hedge fund regulations currently being contemplated by Connecticut lawmakers. He's calling for the federal government to step in an enact laws or regulations so that Connecticut won't have to worry about inter-state regulatory competition.

As we learned from DealBook, Greenwich Time is reporting today that there are currently two versions of hedge fund regulation set to come before state lawmakers. The Republican version would require disclosure by hedge funds receiving more than $10 million of investment money from pension funds. The Democratic version requires far more disclosure and seeks to put in place rules to eliminate conflicts of interest between hedge fund managers and their investors.

The Democratic version, of course, has the entire hedge fund industry up in arms since it is the kind of open-ended, transparency seeking, broad disclosure that hedge fund managers loathe to their core. At least, when applied to their own firms rather than the public companies they invest in. And it's got a lot of folks talking about picking up their hedge funds and heading to, say, Wyoming, where the air is cleaner, the mountains make for great scenery and "live free or die" isn't just a sign on the highway near the cheap liquor shops.

But even the Republican version is troubling. It seems tailor built to make sure that only hedge funds with the best legal teams and biggest capacity to absorb regulatory costs can go after investment money from pension funds. Now, admittedly, many pension funds already limit themselves to working with the biggest hedge fund names anyway. By is this something that we want to carve in legislative stone? If anything, by diminishing competition for pension fund investment dollars, it may ultimately harm the ability of pension funds to benefit from investing in hedge funds.

It doesn't take much imagination to figure out how the Republican version got cooked up. Someone in the constituent affairs office of a major GOP big-wig gets a call from someone running a big time Greenwich fund who also happens to be a good fund-raiser. "Hey, yeah. So look. We know you guys are under pressure to do something," says the hedge fund guy. "Here's our proposal. Get something out there that makes it look like you are protecting pension funds from risky hedgies, while making it harder for those little, wanna-be, JV hedge fund guys to go after all those pension fund dollars that are rightfully ours anyway. See? You benefit. We benefit. Pension funds are protected. Every one is happy."

Ain't democracy grand?

Connecticut Considers Stricter Hedge-Fund Rules [DealBook]

State readies for a debate on regulation Lawmakers mull ways to oversee funds without driving them away [Greenwich Time]