Bailed-out insurance giant AIG is cutting what it owes to the government — in a way that makes the government’s distortion of the economy even worse.

WaPo reports today that in return for a $25 billion debt reduction, AIG has completed a previously announced deal to transfer stakes in its American International Assurance (AIA) and American Life Insurance Co. (Alico) units, both among AIG’s “crown jewels,” to New York’s Federal Reserve Bank.

Apparently, then, someone, somewhere thinks that it is a good idea for the Federal Reserve to own pieces of private companies.

Yet the Fed, under some pending congressional versions of President Obama’s financial-regulatory overhaul, is also supposed to be some sort of “systemic risk regulator” for the entire financial system, which includes important global insurance companies.

How can the Fed regulate companies that it owns — especially if it feels political pressure to get a good deal on the government’s investment?

Rep. Ron Paul wants to “end the Fed,” although, in Congress, he’s flexible and he’ll settle for an audit. Both of these ideas are foolish distractions from how to fix financial regulation.

But when the Fed does stuff like this, it makes it easier for foolish ideas to get a public hearing . . .

— Nicole Gelinas, contributing editor to the Manhattan Institute’s City Journal, is author of the forthcoming After the Fall: Saving Capitalism from Wall Street — and Washington.