The Politics of Decline

It seems that the leaders of both parties are following misguided paths in response to the crisis. The Democrats are abusing their spending powers by throwing out great slabs of pork to their supporters, while inventing new permanent welfare programs and expanding old ones. The Republicans think that when the ship starts taking on water the best response is to ignore it and even try to prevent the captain from transferring crew from the engine room to fix the breach.

 

Both sides are playing political games at exactly the worst time. A major bank bailout is simply necessary to prevent a collapse. A collapse would result in unmanageable government deficits, since revenue would dive and most expenses are fixed. But, the more aggressively this crisis is addressed, in monetary and fiscal terms, the less severe and costly it is likely to be.

 

And, in future, any financial institution that is "too big to fail"--regardless of the form it adopts, whether bank, hedge fund, I-bank, or something else--must not be allowed to undertake such risks as have a significant likelihood of causing systemic collapse. To avoid moral hazard, the holdings of those who wish to pursue such high risk strategies must fall below a certain size threshold. This way no one will expect a bail out if his strategy fails and no failed strategy will mandate federal intervention. The problem is that the guys managing the bad investments were, in the main, managing other people's money--and their incentives were consequently misaligned. They benefitted hugely from success, but did not suffer significantly from failure. This meant that high risk strategies were their best bet personally. Their incentives diverged from those of their investors. These guys should receive the majority of their pay in the form of out-of-the-money options in their investment funds or banks that don't vest for 10-15 years--this should help bring their risk/reward analysis on their investments into line with what is optimal for their investors and shareholders. I would not invest in a financial firm that failed to adopt a compensation structure of some kind that had this essential effect.