‘Too big to fail’ means we all fail

07/21/2009

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The belief that some companies (Bear Stearns, AIG, General Motors) are too big to fail is a dangerous precept that erodes one of capitalism’s basic tenents - risk and reward.

As George Mason University economics professor Russell Roberts points out in The New York Times, capitalism is predicated on profits and losses.

“The profits encourage risk-taking,” he says. “The losses encourage prudence. For decades, government policy and action have discouraged prudence by bailing out or taking over virtually every significant financial institution that has acted recklessly.”

Roberts argues that the bigger mistake has been the bailing out of too many firms rather than too few, and adds some sage advice:

Five years ago, well before the crisis, Gary Stern and Ron Feldman of the Minneapolis Fed, wrote “Too Big to Fail,” arguing that the continual rescue of debt holders and creditors was creating systemic risk in the financial system.

They pointed out the crucial role that debt holders and creditors play in monitoring and restraining risky investments on the part of financial institutions. By consistently bailing out creditors, the power of that restraint was being destroyed. They argued that we were encouraging excessive risk-taking and destroying the natural feedback loops of prudence that would otherwise restrain bad behavior.

They were right, but no one listened. The same mistakes continue. The ongoing rescue of virtually all creditors and counterparties of insolvent firms, rewards recklessness, creates an impression if not the reality of crony capitalism, and sows the seeds for the next financial crisis.

Think of it like this: If you’ve ever been at a ballgame and given a kid $10 and told them to go get themselves a snack and asked them to bring you back the change, they nearly always come back with a lot of food and very little money left over. There’s no incentive for them to be prudent.

If, however, you give them the money and tell them to get themselves something and then add that they can keep the change, they tend to be much more judicious in their spending habits.

Right now, we’re effectively giving big business a blank check and then telling them results don’t matter, there’s always going to be more money available. That’s hardly a recipe for business success.

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One Response to “‘Too big to fail’ means we all fail”

  1. euandus Says:

    How about relying not only on regulations, but also considering Paul Volcker’s advice from experience: being too big is itself a problem that can and should be remedied? I’ve just posted on it at http://euandus3.wordpress.com/2009/10/25/bigger-banks-too-big-to-fail/

    You might want to read the article I read: http://www.msnbc.msn.com/id/33477077/ns/business-the_new_york_times/

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