5/30/2009

Moral Hazard: Wall Street to Detroit to California??

The following is an excerpt from the March 16, 2008, edition of "FOX News Sunday With Chris Wallace":


WALLACE: But there's an overarching philosophical and policy question here that I want to try to get at with you about the government's role.
Why should the government, and thereby U.S. taxpayers, bail out lenders and borrowers who made bad decisions? And if they know they're going to be bailed out, what does that do to the moral hazard argument that they don't end up paying a price?
HANK PAULSON: Well, first of all, I really understand the moral hazard argument. So on the one hand, you've got a moral hazard. On the other, you've got what's right for the markets, what's right for the stability of the financial system, the U.S. economy.
All of these situations are situation-specific, depending on what's going on in the markets at the time. You're jumping to a conclusion about what the cost is going to be to U.S. taxpayer. So I just want to point that out.
And this situation hasn't played out yet. And wait and see how that plays out.
But to get to your general question, this is something that — you need to balance these two considerations. And I would say at this time, given where we are, and given how important it is to minimize disruptions in our capital markets, and how important it is to protect the economy which you were talking about earlier, this was the right decision.
The reason we are bailing out GM and Chrysler is that the government has deemed them both "too big to fail". I think this is ridiculous and nothing more than a convenient explanation for a very inconvenient reality which allows politicians to claim they are acting in the good of all taxpayers by bailing out the car companies. Below is a post by Robert Reich from October 2008 in which he directly addresses this concept:

According to Treasury Secretary Hank Paulson, the biggest Wall Street banks now getting money from the government are just "too big to fail.” Fed Chairman Ben Bernanke uses a different euphemism – he calls them “systemically critical.” The point is that if any of them goes down, it could take the whole financial system with it. So we taxpayers have to keep them up.

We’re hearing the same argument elsewhere in Washington for saving General Motors. It’s just “too big to fail.” So Congress is considering a bailout that would keep GM afloat and sweeten a merger between GM and Chrysler.

Pardon me for asking, but if a company is too big to fail, maybe – just maybe – it’s too big, period.

Reich makes an excellent point, but hardly addresses how to overcome this misconception that anything can be too big to fail. Very few policymakers are willing to acknowledge that there should be no such thing as "too big to fail" because the consequences of failure may cost them their jobs and influence, which is unfortunate because I thought the whole point was to eliminate all of the systemic risk in the system, not keep the same idiots who got us here in their jobs.

This doesn't even get into the reality that the car market in the US has hit a saturation point and people don't need to buy cars as bad as GM would like us to believe. Even if this Chapter 11 plan works and GM restructures into a more efficient entity, is the government gonna subsidize American households to buy a new GM car to maximize the value of their equity stake? Will they pass laws that create disincentive to buy foreign cars? I just don't see an end-game in the whole auto bailout, but if anyone has any ideas I would be happy to hear what they have to say. 

I consider the Obama team to be essentially a bunch of well intended control freaks who consider it there duty to do something, anything, to avert failure. I am eager to see what happens when California fails, which is no longer just a possibility, it is absolutely inevitable. Bailing out California as a state somehow "too big to fail" would be disasterous because no matter what terms the Fed's impose on California, there is no way we can trust them to fix the underlying problems that caused the state to go into this irrecoverable nose-dive in the first place (problems we can certainly get into if anyone is interested).

Where does the Moral Hazard end?
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