Wednesday, September 17, 2008

The Sherman Bailout Policy

The financial market was hoping to be bailed out - ehem, to be reassured of the Fed's concern for their welfare. So they hoped for a generalized bailout in the shape of lower interest rates and higher inflation (to wash away their speculative sins by reducing the real value of their negative net worth).

When the problem is localized (say, when one of the world's biggest insurers is about to go bankrupt) the solution is not to lower interest rates for everybody. It's to take over this (or that, or the other, or the one over there) institution that is too big to fail and put it in sound financial footing. So, with support of the Treasury, the Fed decided to do so.

Problem with this? Moral hazard. Heads I win, tails the taxpayer loses. If things go well, I get the mansion. If things go badly, I still get a (smaller) mansion, but the taxpayer pays the debts.

How to avoid it? Tough question. Here are some solutions: kick out the management. Make the investors lose their shirts, shoes, and underpants. Sue the culprits ... any culprit, left and right, up and down, real and apparent. Make it clear that "bankruptcy is not nice."

The idea is: if the company you run is too big to fail -- if its failure would spell ruin for millions of innocent bystanders -- we take care of the innocent bystanders by offering, say, an $85billion loan. But if you gambled and you lost, we should make sure that you really, really lose.

Let's call this the Sherman bailout policy. (Not after John Sherman, the Ohio Republican author of the Sherman Act, but after William Tecumseh). "If you make a dumb mistake such as secede from the Union or invent, sell, buy, or hold ridiculous makebelieve securities, we'll spend our blood and treasure in restoring calm, order, and normalcy. But goshdarnit, you'll regret the day you thought up the idea."

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