Adumbration

A friend sent me the linked article, so I responded as follows... originally 3/9/2009... lightly edited since then

It's mis-stating the situation to blame free markets on the recent financial crisis when a free market would not protect fraudsters and financial idiots from their own risky behavior.

Such protections have a long history, which effect has been to make subsequent claims of being "too big to fail" appear all the more dramatic.  The more recent examples include Continental Illinois (in 1984) and Long Term Capital Management (late '90's, concluding 1998), which were bailed out after engaging in risky financial business that crashed down atop them. Bear Stearns is more memorable from the last 8 months, and AIG of course. None of these firms or the others should have been bailed out and saved from their stupid mistakes. They should have gone into receivership or whatever is the standard methods of settling assets with creditors, and leave the stockholders with whatever might have been left over.

Instead, not only were those guys bailed out, it was followed by that of several others. They don't call this moral hazard for nothing. It's also called privatizing the rewards and socializing the losses, and is a hallmark of our mixed economy.

But not everyone gets the largess. And that mixed response is part of the problem now. The Feds have a ton of money to pass around, but the rules for getting it change by the whim of the politicos in charge of it. Just think back to last October when the first $700B was approved; the advertised purpose before the law turned out completely different just a couple weeks later.

Is it any wonder then that remaining investors are holding back, not knowing what to do? The rules are up for grabs and there's no clear sign that decisions made today based on today's rules will still be profitable tomorrow. There are vultures out there who would be willing to buy up those "toxic" assets, were it not for the bailout money giving hope to the current holders that they might get something more, and fear to the potential buyers that their risk/reward balance will tilt away from them. This is what is keeping those assets from clearing and the flow of capital from loosening up.

Doubtless there could be better monitoring and oversight, but keep in mind the structural provisions that regulations drove into the system, by for example mandating only "AAA" ratings on certain portfolios. And credit default swaps traded on exchanges rather than over the counter would have given the exchanges very great incentives to keep things under control.

The way to punish fraud is with jail; the way to punish hugely bad financial decisions is to leave those people with nothing - zero - zip - nada. That's what the free market would do.

Would that completely preclude the prospect of bystanders being hit by the backlash? Probably not. But enforcement of no bailouts, ever, would make everyone that much more prudent. And our current approach of selective bail outs sure hasn't kept the backlash from happening.