Arnold Kling  

James Hamilton on AIG

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He doesn't like the distribution of pain.

I accept the argument that a complete failure of AIG would have unacceptable consequences. The relevant question then is, what combination of parties is going to absorb the loss?

The concern I wish to raise is that any reasonable answer to that question would include Goldman Sachs, Merrill Lynch, Societe Generale, and Calyon, to pick a few names at random, as major contributors to this particular collateral-damage-minimization relief fund. But if they are to contribute, the plan must be something other than doling out another $100 billion every few months to try to keep the operation going a little longer, but instead requires seizing this bull by the horns.

He might like the stern sheriff solution.

[UPDATE: See also David Leonhardt on looting.]

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COMMENTS (5 to date)
Alex writes:

When I am reading something like that I could not stop wondering how many more generations of economists it would take to figure out these trivial truths:

1. Capital markets (as opposed to say manufactured goods markets) are essentially systems with short term positive feedback and hence, they simply have to oscillate, regardless of any other factors (very similar to tens of oscillators found in any computer needed to read this post). And hence the only systematic way to deal with problems these oscillations create is to reduce size of these markets to whatever minimum (e.g. by abolishing corporate income tax and taxing capital gains as income) is possible.

2. Limited liability model that encourages a regular business to take reasonable risk simply does not work when we are talking about business of managing other peoples' money or playing with oscillations of capital markets - it encourages taking of unreasonable risks. We have to invent something else.

3. Society as a whole cannot save for retirement - all savings will be simply eaten by inflation when the mass of retirees will start using the saved funds. Pay-as-you-go taxes is the only way to fund society-wide retirements. So we have to stop wasting efforts inventing yet another magic bullet saving plan and start thinking about designing workable solutions involving taxes.

Mike writes:

Hamilton makes a good point but is not as direct and to the point as needs to be said. When you boil the AIG problem down to it's essence the government is between a rock and a hard place.

If they take the tough love approach and stop the AIG bleeding you get a potential falling cards/systemic risk via the counter party's dependence on AIG's honoring their CDS contracts. Arnold's "Stern Sheriff" solution implicitly assumes the counter parties were partially complicit in creating the problem as if they were Las Vegas high rollers placing big bets on the credit default table and AIG was the house and now want to have their bets paid off. Since it was only a gambling debt they really don't have to be paid off. If,however, they were legitimately trying to prudently limit their risk exposure but didn't have the foresight to see that their counter parties could not make good on their side of the trade when the housing market collapsed then the "Stern Sheriff" or the "tough love" solution of forcing AIG into bankruptcy would suck these "innocent" bystanders into the vortex of the systemic "black hole."

What I think is really going on is the government in effect is taking a less politically embarrassing approach to bailing out AIG's counter parties using the shell remains of AIG to provide political cover. If AIG were to be cut loose the problem would metastasize into having to bail out a number of high visibility CDS counter party firms not the least of which would be some major foreign firms. Can't you see the prospect of using TARP funds to bail out important European firms. AIG's name is mud so pouring bail out funds into it masks the fact that it is really bail out funds going to counter parties.

Dan Weber writes:

Interesting moral question. Even if Goldman Sachs knew that the only way they would get paid is if AIG got bailout money, was it "wrong" for GS to exploit that? Especially when they were competing against other folks who may not have been so noble?

I think AK has brought up the point about reducing risk before: even if we make the markets "safe" from wild swings, doesn't that safety encourage even bigger takings of risk?

Cory Chomic writes:

We have mountains and mountains of bad debts in the banks and in the government. There is absolutely no mystery here about what has to happen. Losses have to be recognized and finally settled and cleared, but no one really wants to do that. They just want to pass the hot potato around, and the prudent taxpayers will end up holding it like always. And if the system survives this recession the stage for the next even larger one will be set, and the play will likely start in 8-10 years.

Tyler L writes:

Cory Chomic makes a valid arguement. Our banks and government are burried to their hairlines in debt. And no one is willing to step forward and accept the responsibilities. Taxpayers are left with the countries mistakes weighing like a heavy necklace. Why doesnt everyone make a front and get the countries debt knocked out?

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