Sunday, March 01, 2009

What Vegas Can Teach You About the Recession

In last week's EconTalk, economist Allan Meltzer argued one of the main reason for our current financial mess is the Fed's policy of too big to fail. If a large financial institution collapses, it will harm countless other institutions and hamstring the the market as a whole. By preventing disaster and saving these companies, the Fed saves the economy. Knowing that in the worse case scenario someone will help you out, these banks then took riskier chances than they otherwise would. Thus the mess we're in now. In a world of superheroes, there are more extreme athletes.

Some are skeptical of this relationship, made evident by the fact that this is not at the forefront of the popular debate (the much more vague and non-scientific "animal spirits" is). But suppose you went to a conference in Las Vegas and your company agreed to reimburse you for any gambling losses you suffered during the trip. It's obvious that you would gamble more. And you would take bigger risks. Why wouldn't you?

You could point out that the companies are worse off than those that didn't take the housing gamble (such as JP Morgan Chase, Pittsburgh National, Wells Fargo). But they are better off than if the Fed hadn't intervened at all. If the company compensates you only half or a third of what you lost from gambling, you would still gamble more but not as much as full compensation. Regardless, this policy would immediately prove to be a terrible idea. But that's the rule in place at the Fed now.

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