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.
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March 21, 2009 at 7:52 am
Morph366
You are right to point to externalities as the real problem that most of our cultural leaders and economic policy makers refuse to address. It is a blatant form of denial and ignorance (i.e. ignoring unpleasant and inconvenient truths). But is all pervasive and extends beyond the financial realm
As a culture we have persistently failed to factor in the costs of ecological degradation and systemic financial failure in all of our decision making because markets do not know how to properly measure these costs and because no one is really challenging them to do so. Certainly governments and financial technocrats don’t have a clue how to measure them either.
Of the two possibilities – markets or politicians – I would expect and hope that it is the former that will eventually figure out how to quantify the true costs and consequences of our action and to lead to a sustainable and ultimately more equitable allocation of resources and risks.
March 21, 2009 at 10:15 am
Link: Pricing Toxic Assets « Cheap Talk
[…] 21, 2009 in Uncategorized | by sandeep Jeff and I blogged about externalities. But there is another aspect to the bailout. How should toxic […]
March 22, 2009 at 7:53 am
James Kibler
I think it is difficult to make any kind of judgment as to whether “markets” are “good” or “bad” based on this case. It is not the case that ‘free markets’ led to a bad outcome. Markets operated under the existing regulatory structure, which included deposit insurance that removed one of the important brakes on risk-taking by banks.
Regulators evaluated deposit insurance ex-ante as ‘good’ because it lowered the likelihood of runs on banks. This evaluation failed to take into account the incentive effects similar to those you mention–risk seeking behavior by banks was encouraged. I am not claiming that deposit insurance is solely responsible for the present bad outcome, or that it is on net ‘bad’. I am merely claiming that regulation did in fact exist, and banks’ response to the incentives created by the regulation contributed to the bad outcome.
Thus, I think to use this as an example of when ‘free markets are bad’ is something of an overstatement.
March 22, 2009 at 12:28 pm
sandeep
Deposit insurance does not affect AIG or Lehman Bros or Bear Sterns, only commercial banks. Subprime lending is not affected by deposit insurance. So, this insurance cannot have the source of these firms becoming too big too fail.
Whatever the source of these institutions getting large enough to exert externalities, once they do so, they do internalize them when they make their decisions. This leads to a case for intervention.
March 22, 2009 at 10:04 pm
guarachero
The entire premise to this argument may be faulty. Does Darwinism truly stand for the proposition that only the strong survive? Survival may be more dependent upon the capacity to adapt than upon strength. Survival of the fittest does not mean only the strong survive.