Sean King

My photo
Knoxville, Tennessee, United States

Sunday, September 21, 2008

Too Big To Fail?

Time and again we've heard the past month's bailouts justified on the grounds that the companies involved are "too big to fail." Using this logic, the government has taken unprecedented steps to prop up certain large companies--loaning money to some and nationalizing others. The problem with this approach is that it is inherently anti-capitalist, and it seeks to protect certain people and companies from the natural consequences of their own actions. This, in turn, presents a severe moral hazard.

As a result, some are arguing that any company too big to fail should also be deemed too big to exist. They argue that the US should amend its anti-trust laws to permit the federal government to break up companies that become "too big to fail" long before they have any chance of doing so. While this approach is inherently anti-capitalist as well, it does have much to recommend it in my view, at least as compared to the "bailout" approach. Its primary advantage is that the failure of smaller companies would presumably not present systemic risk to the economy, thus doing away with the justification for government bailouts and eliminating the threat of moral hazard.

However, such an approach is not without its own costs, disadvantages, and limitations, not the least of which is the role of partisan politics in deciding which companies have become "too big." But, most of these costs, disadvantages, and limitations are inherent in any government action. At least this "anti-trust" approach doesn't distort the market with the same perverse incentives that bailouts do.

For instance, with the bailout approach, what's to keep these too-big-to-fail companies from making the same mistakes that got them into this mess originally (e.g., assuming too much risk by over-leveraging)? As a result of these bailouts, don't they now have an even greater incentive to do exactly that? They can now count on the government to rescue them when their risky bets don't pan out. For these companies, it's now "heads we win, tails the taxpayer loses", and that is a formula to make things worse, not better. By attempting to protect the public from the consequences of these companies' irresponsible conduct, we are in fact encouraging more of the same.

Those who favor the bailout approach argue that we can prevent these too-big-to-fail companies from gaming the system via regulation. For instance, they argue that we can prevent over-leveraging by simply having laws on the books that outlaw it. The problem with this approach is that, as the present crisis demonstrates, financial markets and companies evolve much more quickly than regulations ever can. Today's regulatory structure, which was updated as recently as the 1990's, was ill-prepared to regulate many modern and novel of financial instruments (e.g., certain derivatives, certain collateralized mortgage obligations, etc.). Regulation will always lag the market, for political reasons if no other.

In the long run, I think the country would be best served if the government did nothing and simply let the market sort things out. The market is brutally efficient in the long run, and left alone, it will more than adequately punish those who took excessive risks. In doing so, it will provide a great disincentive to like-minded individuals who may be tempted in the future to repeat present mistakes.

But, I also recognize that most people choose short-term gratification and comfort over long-term good health everyday. This is as true in matters of finance as it is in matters of diet, maybe more so. So, since this is a democracy, the immediate gratification that comes from increased regulation is inevitable. I simply argue that regulating company size is easier, less intrusive and less perverse than the proposed alternative: Attempting to regulate market conduct while at the same time bailing out too-big-to-fail companies when those regulations ultimately fail to keep pace with changing times.

1 comment:

Anonymous said...

I knew you'd make a great post about this.

-- Your Sister