Lessons Of Aig

I’ve gotten a fairly big response to the following (quickly written) piece in the Washington Post on Thursday:

The AIG debacle teaches us two things. First, it does not make sense to try to save any single financial institution. Failed enterprises should fail – and go away. The government should only be in the business of preventing too much collateral damage to the economy. Had this been the focus from the beginning, taxpayers would not have the specter of their funds going to pay bonuses. And they would have been prepared for the fact that their money would flow to banks, hedge funds, and every other sort of creditor of AIG as part and parcel of appropriately minimizing financial contagion.

The second lesson is that no matter how bad you think market capitalism is, the Federal government has proven it is worse. The Congress originally banned these very bonuses, then stripped the ban out of the stimulus bill, and is now threatening confiscatory taxes on the lawful recipients. The Treasury knew about the bonuses and vouched for their legality but now wants double the money back somehow. How, exactly, the Treasury expects any straight-thinking financial entity to enter into a voluntary public-private “partnership” to solve the financial crisis in light of this track record is a mystery to me.

In light of the e-mail traffic, let me expand a bit. I remain convinced that the financial crisis is the greatest threat to the U.S. economy. It should be the top policy priority and, since I think it will be very expensive, the top budgetary priority as well. Unfortunately, at the moment it does not appear that either the public or the Congress displays any willingness to devote more taxpayer dollars to addressing the crisis. We need to shift the policy tactics and the public perception right now.

The right thing to do is to apply the principles of responsibility and competition, and the lessons of history to get this right. The most important lesson is that failed, insolvent banks cannot be permitted to continue to operate using taxpayers’ subsidies. Letting these “zombies” walk the financial system was at the heart of the savings and loan crisis and the slow Japanese recovery from its financial crisis. These institutions should be taken over, their management and shareholders suffer the consequences of their failure, and the assets re-sold to private sector entities as fast as is feasible. That’s good policy: discipline failure, promote real competition, and use assets effectively in the private sector. (Adam Posen is really smart on this topic. Read his testimony, here.)

Doing business that way eliminates “bailing out the banks” and “saving AIG” from the public discussion, and hopefully will make taxpayers more willing to open their wallets to solving the problem. Yes, it will be costly – but the cost is the price of not allowing the unwinding of individual institutions to cause a chain reaction of financial collapse. That is, the taxpayer money WILL flow through an AIG, for example, to those with which the failed institution has contracts. They may or may not be made whole, but they will not be stiffed entirely. The public will have to understand that this is the appropriate role for the federal government: preventing widespread collateral damage.

The other key aspect of this strategy is the rapid-as-possible sale of assets to the private sector. We have to get these institutions and their assets out from under the thumb of the Administration and Congress, whose behavior toward anyone receiving taxpayer dollars has gone from bad to appalling. Any reasonable analysis of the situation recognizes that additional private capital is central to recovery. But why would private capital run the risk of being enmeshed in a situation so blatantly political that every dollar would be at risk? It is time for some rules of the road that rely more heavily on qualified third party conservators and asset managers and freed from direct government interference.