Why creditors should suffer, too

That is my latest column and the core point is straightforward:

What the banking system needs is creditors who monitor risk and cut
their exposure when that risk is too high. Unlike regulators, creditors
and counterparties know the details of a deal and have their own money
on the line.

But in both the bailouts and in the new proposals, the government is
effectively neutralizing creditors as a force for financial safety.
This suggests a scary possibility — that the next regulatory regime
could end up even worse than the last.

Do read the column for a discussion of how we might make creditors suffer.  Here is why the Obama administration is having such a tough time with the issue:

Right now, people cannot understand why A.I.G. received bailout
money, so they feel deceived. A single insurance company, even a very
large one, just does not seem that essential to the American economy,
which makes the company all the more a scapegoat. Much went awry at
A.I.G., but in the context of a bailout, the company should be thought
of as the conduit for helping an entire market that went bust.

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to
promise to pick up all future obligations to major creditors. At the
same time, any remarks that threaten to leave creditors hanging could
panic the markets. So silence reigns, the Fed and Mr. Geithner receive
bad publicity over the bailouts, and we are all laying the groundwork
for a future financial crisis.

James Kwak offers comment.  Here is Arnold Kling.  Mark Thoma has very good comments on time consistency problems.


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