How to Avoid Financial Trouble

Get too big to go bankrupt. Isn't that what AIG just did?

Well, sort of. The stockholders took a massive hit, and the US gubmnt now has what, over 79.9% ownership of AIG?

At the same time I wonder if Washington Mutual is trying to do something similar.... get too big with too many entangled loans and swaps to be allowed to go under.

• As an aside, back in 1985 I asked David Laidler whether Canadians could afford not to let the Bank of Montreal go belly up when it was in financial difficulty as a result of a number of really bad loans to foreign gubmnts and companies. His response was that by then that bank was already too big to let them go under.
• I expressed concern about moral hazard, and he said that any bail-out plan should require that top management be replaced and that stockholders lose their entire investment. I won't hold my breath to see if that happens at AIG.

For an interesting suggestion concerning firms that get too big to allow them to fail, see Mike Moffat.

Not surprisingly, the recommendations by Joe Stiglitz involve

1. Blaming the Iraq war and
2. Recommending several more layers of bureaucracy

without homing in on the problem that reasonable people kept expecting that they could pay others to bear the risks of holding the collateralized debt obligations --- something that worked so long as the insurer of last resort was well-capitalized.

The trouble is that once the gubmnt becomes the insurer of last resort, it then also assumes a role of regulator/monitor/interventionist, a role guaranteed to increase economic inefficiency.

Comments

[Tom Hanna]

Most of the analysis seems to focus on moral hazard. Does the picture change if you focus on the negative externalities of a allowing a bankruptcy that would put innocent third parties (and third parties five or six places removed) at risk? Put another way, aren't all these bailouts just big Pigouvian subsidies?

[Mike Moffatt]

Thanks for the link!

I don't really believe my own idea, but it seems to be the least-bad of all the suggestions out there.