“What if Bear Stearns had been allowed to fail?” My answer: firms would’ve gotten their financial houses in order 6 months earlier, with house prices 10% higher, and capital still available. Instead, we get moral hazard run rampant, as firms avoid painful capital raisings just as they kept the plates spinning in late 2007 just long enough to snag humongous bonuses.

Of course, investing and economics are both social sciences (or at least social arts), so we can’t re-run history to verify either counterfactual.

However in my opinion in a fair society economics would be much simpler. Private businesses could be considered inappropriate mechanisms to control money. The nature of money has always been maluable but has become far to broadly defined.

Money should be restored to the service of the economy away from something which is being used to distort the economy. The function of money to serve the economy has been kidnapped by the central banks and governments and put to the task of trying to make people happy. The finance community has happily colluded and made themselves very happy in the process.

it seems to me that the slow response of the authorities has a lot to do with the mess we find ourselves in

No one can accuse Ben and Jean of being stingy with the cash, they have opened the spigots wide, and the public have reluctantly accepted that it was the right thing to do. Furthermore they have been quick to the mark in handing out cash to all and sundry for the crappiest of collateral. If this was a liquidity problem, as in a run, the problem would be over.

The government can’t fix this mess, it only drags out the inevitable and at probably greater cost. This current state of affairs will drag out till asset values reflect reality, losses are acknowledged and written down, and massive amounts of capital are transferred from taxpayer to the financial system (since of course the consequences of letting anyone fail would be far too horrible). The bill to the taxpayer for this clean up is going to result in a raise in taxes, at the same time the baby boomers start ramping up their claims on the social security system. There’s a lot more pain coming and when its over, it wont be business as usual 2006. Lending criteria will be far more stringent. The cheap money is gone. The business structure based on it’s premise, is now imploding.

For the ayatollahs of moral hazard point of view, that’s a good thing, but it is generally accepted in the literature that crisis time is no time for morality lessons.

No, it’s not time for a morality lesson. But Paulson’s initial proposal of “give me $750 billion, no strings attached” was plainly idiotic, congress would have been negligent in passing it. It recapitalized the financial institutions and left the clowns who ran this circus in place. By all means you should put out the fire, but you don’t let the arsonist off Scott free, or more importantly “compensate” his bad behaviour. Moral Hazard can be addressed imperfectly during a crisis. Recapitalise the financial structure, take ownership, fire the crew.

Risk premiums are now going to reflect financial and political reality. Are you proposing that risk premiums be based on the assumption, that there are financial institutions that are too big to fail, and hence all risk premiums should be sovereign risk? Risk premiums priced on the Soviet model of financial governance?

The underlying assumption of Lorenzo’s friends, is that it is possible to stop a Ponzi scheme from unwinding, and that there is a “right” way to do it. Let’s hope that he is right and I’m wrong.

When management’s priority is maximising profits and shareholders’ interests at the expense of the stability of a sector of systemic importance to the functioning of the economy, such as the financial sector, and distorting the efficient allocation of resources within the economy, the objective function must be broad enough to address this problem of rules, incentives and individual responsibility.