March 21, 2008

It's not as simple as `let them fail'

I've seen some progressive and mainstream voices denouncing the `too big to fail' Fed bailout of Bear Stearns a week ago. I'm much more ambivalent about this sort of thing.

The financial sector of the American economy functions much like a private toll road system. Some roads -- like the one from your savings to your neighbor's new mortgage or small business loan -- are small, low-volume, and highly local. Others, like Bear Stearns, are superhighways, moving tens of billions of dollars back and forth all over the place in both financial and physical space. Bad loans, in this metaphor, are like cars with severe mechanical problems -- no breaks, bad transmissions, maybe a couple cylinders aren't firing. And when lots of them break down in the middle of the superhighway, it gets clogged and slows down. The dead cars have to be cleared out, which adds to the operating expenses of the superhighway.

Now, the superhighway can, as it were, only allow cars that pass mechanical checks to use it. This keeps everything moving along nicely, but it's sacrificing some profit. More risk-friendly superhighway operators aren't going to have such checks, betting that the additional costs from cleaning up after the failures of bad cars will be less than the additional profit from having a higher number of cars move through their system.

Bear Stearns failed, essentially, because it lost this bet. As traffic ground to a halt on the Bear Sterns superhighway due to all the broken cars littering the roadway, the other superhighways closed their connections to keep the backup from spreading to their systems. (Imagine you have an east-west superhighway passed underneath a north-south highway, with a complex series of ramps that allow you to move from one to the other. Now imagine there are barriers that can be lowered to prevent cars from using those ramps. That's essentially what the other giant securities banks did to Bear Stearns late last week.)

This is good, at least in the short term, for the other superhighways, because it keeps them from grounding to a halt along with Bear Stearns. But it's bad, in the medium term, for the economy as a whole, for exactly the same reason suddenly shutting down one of the major superhighways through the middle of a large city is bad. Money/cars still need to move around. Either traffic will be diverted onto other superhighways, which will likely push them beyond their efficient capacity and slow them, and hence the system as a whole, down. Or people will, as it were, just stay home, and not bother trying to fight the nightmare traffic. Money won't move from the people who have it to the people who want it to do things, so people do less things -- don't open new businesses, don't expand existing business, don't build new houses, etc. In either case, economic growth slows down, and there's a potential for recession.

At least, that's the `too big to fail' theory. Closing fifty feet of surface street in the middle of a residential neighbourhood probably isn't going to do much damage -- the failure of small economic players, at least individually, might be inconvenient, but the system will adapt pretty easily. Shutting down a massive superhighway that carries a significant percentage of all the city's traffic will have complex effects that will ripple through the traffic network as a whole, and possibly even damage it severely -- letting Bear Stearns fail could have made the recession even worse.

So, did the Fed do the right thing, in essentially paying another superhighway operator to clean up the mess Bear Stearns made of its system by letting on all the junk cars? Well, they acted to prevent a medium term disaster. The clogged superhighway will be cleaned up. But the incentive to create such clogs will not have been removed. If superhighway operators knew that they would be the primary losers when a massive traffic jam developed on their superhighway, they would be likely to sacrifice some profits and allow only cars that passed mechanical checks onto their part of the system. But they don't know this. They know the exact opposite: that they can create a huge mess, and the Federal government will buy them out. According to a purely self-interested conception of reason, they have no good reason not to just do the same thing again.

It's this last point that critics of `too big to fail' are trying to get at. Or, at least, I think it's the best related point. With a prevalent short term profits mentality, a pure free market system will cease to function efficiently as these sorts of disastrous decisions are made again and again. A more virtuous business culture will help, but the temptation to tempt fate might still be too large. (Remember, Bear Stearns was enormously successful until it finally imploded. Even without the bailout, the former CEO could have walked away from the mess he created a ridiculously wealthy man.) And stopgap, emergency intervention by the government is just that -- it might avert the most looming disasters, but it completely misses the underlying cause of the problem. What the system needs, I think, is vigorous regulation -- the kind that pretty much made these disasters impossible in the '50s, '60s, and '70s.

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