Moral Hazard Misconception – Part 2

Given the dramatic recent events, I can’t help revisiting my old posting. I am even more convinced than then, that had the US Treasury sent an unequivocal signal that it was not going to tolerate speculative attacks — including punishing shortsellers along the lines of Hong Kong’s stock market intervention during the late 1990s (see:http://econ-www.mit.edu/files/180) — we would not be involved in this dangerous scenario. Instead, uncertainty is rampant, as the moral hazard and political caveats (which are a second order issue in the current context) limit decisive and definitive statements. Continuing along these lines is likely to be prohibitive, as it essentially requires that the state buys “everything,” or that, in many instances, extremely inefficient mergers and asset liquidations take place. It is time to put a floor on the price of financial institutions’ stocks, and from then on let the private sector handle the rest, rebuilding much needed capital at fire sale, but not holocaust, prices.

This should be done not for the benefit of shareholders and managers, but for that of the taxpayers. The idea that each bailout is a decision against taxpayers is ludicrous in the current crisis context.

Not only are equity interventions at fire sale prices likely to yield high returns to the public sector over the medium run, but also the unpredictable-intervention/punish-equity model currently in place will cost a lot more to taxpayers and households in terms of lost output, jobs and savings.