Taking Our Medicine
The NYT has a long piece on the financial meltdown in two parts: 1, 2. It’s very much worth reading. One point in particular jumped out at me:
“THERE are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.
Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.
This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992. And remember, the Federal Reserve and the Treasury have already accepted, on behalf of the taxpayer, just about all of the downside risk of owning the bigger financial firms. The Treasury and the Federal Reserve would both no doubt argue that if you don’t prop up these banks you risk an enormous credit contraction — if they aren’t in business who will be left to lend money? But something like the reverse seems more true: propping up failed banks and extending them huge amounts of credit has made business more difficult for the people and companies that had nothing to do with creating the mess. Perfectly solvent companies are being squeezed out of business by their creditors precisely because they are not in the Treasury’s fold. With so much lending effectively federally guaranteed, lenders are fleeing anything that is not.”
I think this is what we should have done. As an approach, it has three great strengths. First, it allows us to quickly separate the sound parts of a business from the unsound parts, and send the sound ones back into the private sector unencumbered as soon as possible. Done right, I think this would do a lot to increase confidence in those bits, especially if we used the occasion to try to discover and publish prices on the unsound assets we thereby acquired.
Second, if it led to carving up businesses that were previously “too big to fail”, I think that would be a good thing as well.
Finally, it would do something serious about moral hazard. Moral hazard arises when people think that (e.g.) a company will be protected from some calamity (e.g., failing), and thus either allow it to take risks or, if they work for it, take risks themselves, that they would not take without that belief. This is a serious problem: we do not want financial institutions to take needless risks because they assume that we would bail them out. On the other hand, sometimes the costs of not bailing them out would be very high, so just letting the creative destruction of capitalism proceed unhindered doesn’t look like a very good option either — especially since that destruction is not visited only on those who in some sense deserve it.
I’ve always thought that one way to deal with this would be to find a way of bailing out firms while sacking their managers and wiping out their shareholders. Bankruptcy does this, of course, but when for some reason letting a firm just go bankrupt looks like a bad option, we ought to preserve the basic principle that even if a firm is saved, the individuals — investors and managers alike — who either took or profited from those risks should be slammed.
The point here is not punishment. It’s creating incentives not to do stupid things. You might think of it as a way of turning the divergence of interests between principals and agents to good account. That divergence creates problems when an agent (e.g., a manager) who is supposed to be working for a principal (e.g., a firm) finds it in his interests to do things that damage the firm — for instance, taking risks that produce short-term profits, and thus large bonuses for him, but that place the firm itself at unconscionable risk. But I think it can also be used for good.
In the case at hand, we want a firm (or significant parts of it) to survive, and we think that bankruptcy is, for some reason, not an option. We thereby risk moral hazard. But if we ensure that even though bad things do not happen to the firm, they absolutely do happen to its senior management and its investors, we might be able to create a set of incentives that work against taking unconscionable risks. After all, if managers know that if things go badly wrong, they will abruptly lose their jobs and their bonuses, they will not be nearly as likely to take those risks. And if shareholders know that they will not be made whole, they will be more likely to ask just how much risk a company is taking, and not to accept blithe assurances in place of real evidence.
But we haven’t done this. We have not asked managers to resign. We have not tried to separate sound from unsound banks, or parts of banks. We have not tried to purge our financial system of the parts that got everyone into trouble. Instead, we have tried to prop up everyone, and to inflict as little pain on the financial wizards who created this mess as possible.
I think this is a profound mistake. I hope that Obama will correct it. If he doesn’t — if we respond to this the way we did to the Long Term Capital Management crisis, by fixing the immediate problems without fixing the system that gave rise to them, or learning any lessons for the future — then we have learned nothing, and deserve the future crises that will undoubtedly come our way.