Keeping the party orderly July 22, 2008 at 8:51 am

A post on VoxEU discusses the debate between Larry Summers style ‘the FED must drop money on Wall Street until the problems end’ interventionists and the moral (and I believe broadly correct) position that banks ought to be left hanging to pay for their sins. Governments ought to be worried about their taxpayers, not bank shareholders. VoxEU calls this the Willem Buiter position, which is not entirely accurate (Buiter’s position is more nuanced) — but let’s run with it.

The argument is that the moral hazard in permitting a Summers style bail-out is too great to permitted:

once banks know that they can play the high-risk, high-return game, pocket the profits, and let taxpayers face the risks, bailouts provide a temporary relief but set the ground for the next crisis.

…Bank of England Governor Mervyn King nicely sums up the situation: “’If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time, the parties will become wilder and wilder.”

This would be true without regulatory capital. But if it works as intended regulatory capital should stop the party from getting too rowdy. The current crisis came about because capital requirements were not effective in constraining banks’ risk. The solution for now is a rescue with shareholder expropriation where necessary for the protection of depositors and the financial system. The solution for the future is getting regulatory capital requirements right. And minor changes to Basel 2 won’t do that.

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