AIG And Its Aftermath

Just when I thought that the age of bailouts had come to an end with the Treasury and Fed agreeing to let Lehman bite the dust for its various poor investment decisions, I am confronted with the Treasury and Fed deciding to bail out AIG.

Needless to say, this is appalling. The Fannie Mae and Freddie Mac nationalizations were explained away with the argument that since Fannie and Freddie were never private entities, they didn’t count in the nationalization game. I worried that the nationalization of those two entities would set a precedent, and thus it has. To the extent that Treasury and the Fed had drawn a line in the sand against further bailouts, that line is now completely swept away. Moral hazard is now officially running amok; companies whose balance sheets reflect problems will now run to the United States government to be the bailout agency of last resort. And why not? On what basis can the United States government say no? If a company is not as big as AIG, it can argue that the government could more easily afford a bailout for it than it could for AIG. If a company is bigger, then it will use the “too big to fail” argument to the same effect that AIG, Fannie and Freddie did. Treasury and the Fed now suffer from a massive credibility problem and the end result is a disaster for any semblance of financial governance and economic integrity.

In order to get that integrity back, Treasury and the Fed must now announce that there will be no more bailouts of any size, shape or form and mean it. That their word will initially be tested should surprise no one but the government must show that there is credibility behind its claim that the bailout culture has come to an end. CEOs, CFOs and COOs must now take it upon themselves to undergo a rigorous examination of their balance sheets to see whether there are time bombs waiting to explode. If problems arise, the best thing to do is to act on the safe side, assume that those problems could be company-threatening and take swift and decisive action to head those problems off at the pass before they become bigger. This means not waiting until the last minute before engaging in merger talks or selling assets in order to raise collateral–a similar delay helped bring about the downfall of Lehman, after all. To the extent that the situation calls for it and to the extent that it is permissible by law, Treasury and the Fed may serve as mediators or arbitrators or honest brokers in any behind-the-scenes activities to save a particular endangered company, but this is as far as government should go; if talks fail, the government should no longer be expected to step in and bail out a particular company. In light of the fact that the Federal bank insurance fund is dwindling, it is impossible to conceive of further bailouts without contemplating severe strain on the financial system as a whole.

We ought to remember as well that failure on the part of companies is contemplated and anticipated by the capitalist system. More people need to be aware of the process of creative destruction that Joseph Schumpeter described; it is through that “destruction” that we achieve success and innovation in the future because the market’s power to reward good and smart actors and punish bad and stupid ones is a sine qua non for socioeconomic success and innovation. The genius of capitalism, however, is not that it puts more money in your pockets (though it does), or that it raises your standard of living (though it does), or that it leads to medical, technological and scientific breakthroughs (though it does), or that it leads to innovation on a whole hosts of fronts designed primarily to help the consumer (though it does). The genius of capitalism runs deeper than that. It stems from the fact that because of capitalism, we are well-positioned to learn from our mistakes. We will still make mistakes in a capitalist system but we will come back stronger thanks to capitalism’s regenerative aspects, which assist us in learning what we did wrong and learning how to do right the next time. Our ability to be educated is greatly enhanced thanks to capitalism and if we throw the capitalist baby out with the bathwater, the current credit and housing crisis will look like a walk in the park compared to what we will have to contend with next.

Of course, the current mania is to call for increased regulations. Barack Obama is already on the case, having gone on record as blaming the policies of the Bush Administration for the current credit crisis. How the Bush Administration was supposed to get companies like AIG to refrain from investing in subprime mortgage derivatives is, of course, anyone’s guess and Megan McArdle–herself an Obama supporter–does an excellent job in dismantling her candidates pabulum here, here and here (in which Obama is specifically taken on). It should be added that calling for “more regulation” is about as useful as calling for “more cowbell.” How are regulators smarter and wiser and better-looking than other people? Seriously. How? Because that is essentially the nonsense that so many have bought into; the belief that regulators are magical beings with magical powers that will prevent us from making silly mistakes with our own money or with other people’s money. You know, I don’t think that we lack for regulators in this country. I certainly don’t think that we lack for regulation; browse around and look at how unbelievably massive the Federal Register is. Try to remember as well the various crises with Enron, Worldcom and all the other bad actors from years past. We decided to opt for more regulations to combat said bad acting by passing the Sarbanes-Oxley Act. I had argued six years back that perhaps opting for more regulation was premature, but of course, no one listens to a blogger. But there were a lot more people who were and are and always will be more famous and prominent than little old me arguing the same thing. They–we–were not listened to. How did Sarbanes-Oxley turn out? Ahem. And there is a lot more where that came from.

It is a shame, of course, that these issues are mostly being ignored. We could lessen the pain that the economy is suffering through if we get smart about matters. Unfortunately, we are too busy treating symptoms instead of the disease and seeking to wreck the corpus economicus altogether through unnecessary and destructive regulation.