Two economists, Peter Boone and Simon Johnson, argue that the recent bailout is merely another installment in a cycle that, if we continue on our current trajectory, will lead to a crash on par with that which precipitated the Great Depression.
The doomsday cycle has several simple stages. At the start, creditors and depositors provide banks with cheap funding in the expectation that if things go very wrong, our central banks and fiscal authorities will bail them out. Banks such as Lehman Brothers – and many others in this past cycle – use the funds to take large risks, with the aim of providing dividends and bonuses to shareholders and management.
Through direct subsidies (such as deposit insurance) and indirect support (such as central bank bailouts), we encourage our banking system to ignore large, socially harmful ‘tail risks’ – those risks where there is a small chance of calamitous collapse. As far as banks are concerned, they can walk away and let the state clean it up. Some bankers and policymakers even do well during the collapse that they helped to create.
They argue that the current regulatory system is broken and needs a fundamental overhaul. Perhaps this is true. But if banks and other lenders knew for a fact that if they invested irresponsibly and things went sour they would NOT be bailed out by the government, would they act more responsibly? If so, at least part of the trouble is not inadequate regulations but a safety net that distorts the true cost of risk. Let ’em fail. But, many reply, if they fail, they will bring down the entire economy. If so, the solution is clear: break them up. The only other alternative is to increase government control over those entities whose failure threatens everyone.
h/t Steven Rybicki