Why should we bail out big banks?  Capitalism and Darwinism are closely related – only the strong survive.  Bailing out the weak and unprofitable wastes resources and reduces efficiency, undermining the benefits of capitalism.

One response to this perspective is to get all lovey-dovey like David Brooks on one of his bohemian days.  Embrace social Darwinism rather than the selfish gene.  Bail out your fellow man as he is your fellow man.

But there is s a much simpler and standard explanation: externalities.  If a small firm goes under there’s no problem.  The depositors are insured and the main burden falls on the management and employees of the bank itself.  They should not be rewarded for bad decisions.  That would be bad for incentives and efficiency.   Capital and labour flows to better uses.

If a big bank goes under, there is a ripple effect thoughout the economy and we start hurting good businesses who are not to blame for bad decisions by the big bank. This reduces output more than justified on efficiency grounds. And this justifies intervention. It has nothing to do with hurting for your fellow man – it is hard-headed economic calculation.

Unfortunately, this creates an additional incentive problem.  If big banks know they are going to be bailed out, they have the incentive to take on risky projects that payoff big when they succeed as they get bailed out when they fail.  They do not fully internalize the impact of their decisions.  This is like the classic problem of the polluting factory that does not fully suffer the environmental impact of its pollution.

What is the solution?  Eric Maskin and Roger Myerson (Nobels 2007) either hint or are explicit about their answers.  Some kind of regulation is necessary.   Banks might be forced to have larger reserve requirements as they become big.  Or it might simply not to be allowed.

So, to summarise: we have to bail out big banks as their failure has large, external effects.  Because of this, to prevent moral hazard, we either have to regulate to keep banks small or impose higher capital requirements so they grow responsibly.

This ideas are simple but it’s great to see Sheila Bair, head of the FDIC, embracing them.  Maybe the ideas are in fact not that straightforward as they do not fall easily into the “markets are good” markets are bad” dichotomy.  Free markets are sometimes bad is a more complex message.  But I think it is the slightly right-of-centre philosophy that someone like David Brooks should embrace.