OBSERVATION OF THE DAY. There is no such thing as an unfettered or unregulated market. Arnold Kling at Econ Log.

My view is that financial markets are inherently unstable, because financial intermediation inherently replaces transparency with trust. If my bank were perfectly transparent, then I would know everything about its loans, including the underlying risks of the real estate developers, small businesses, and individuals to whom it is lending money. But in that case, I would not need a bank--I could just make those loans myself. So if you assume perfect transparency, you assume away the need for financial intermediation.

In fact, you have to assume the opposite of perfect transparency. You have to assume highly imperfect transparency, with reputation and trust serving as substitutes.

But where there are substitutes, there are tradeoffs.
In banking, deposit insurance helps facilitate trust. A private insurance pool might work, but people trust government-provided deposit insurance even more.
We don't know that for sure, because the 1933 credit crunch and the subsequent Federal Deposit Insurance Act imposed government-provided deposit insurance. In 1933 nobody thought about deposit insurance as a put option for a portfolio of high-flying mortgage-backed securities.
With deposit insurance, the consumer loses all motivation for worrying about the bank's risk management. By the same token, the insurer has to worry a lot. In the U.S., the FDIC has been getting better over the years, but you can never get complacent. Any system can be gamed eventually, so it's a challenge for the regulators to stay one step ahead of the banks.
Here's a research puzzle: does it have to be the case during a rational expectations hyperinflation that all lenders behave in the same way? There has to be money on the table for lenders and borrowers that offer preservation of capital despite lower quarterly returns (until the bubble pops, that is.) Must a pooling equilibrium in which all savers and all financial institutions deal in the same mix of ultimately tainted securities be the necessary outcome?

What, then, of the bailout of trading houses that don't deal in insured deposits? Mr Kling continues,
What we see with Bear Stearns, Freddie and Fannie, Lehman, and AIG insurance are institutions that are not FDIC-insured banks where nonetheless a question arises about whether some of their creditors ought to be protected by the government. I think that just about everyone is unhappy that these decisions are being made ad hoc, after the firms got in trouble, rather than having rules set ahead of time. But maybe what the government is doing is actually pretty reasonable. You can think of the Fed and Treasury as trying to buy good assets at cheap prices, at a time when private intermediaries have lost the trust of investors, which puts undervalued assets out there to buy. But you want the government to get out of the hedge fund business sooner, rather than later. It's not a safe business.
That's possible, although it's optimistic. The Fed and the Treasury might clean up on this, or they might be put in the position of having to print money. We shall see.

The editors at the Milwaukee Journal-Sentinel don't like the precedent the AIG bailout establishes.

The government threw out management - a good thing - and gained rights to 79.9% of AIG stock. The terms of the loan are rigorous, with the government demanding credit-card-like rates. The Fed claims "the interests of taxpayers are protected" because this monster loan is backed by AIG collateral.

Taxpayers should be skeptical. No banks would touch this deal, which calls into question the value of that collateral, and there is a real risk that the government will be forced to lend the company even more money down the road.

Worse, despite the tough terms, the Fed has bailed out a company that it doesn't oversee and doesn't do business with directly. Count on the Fed and the Treasury Department - not to mention Congress - to hear from other companies.

They conclude,

So, yes, there is a good argument for the government's action in the case of AIG. But after refusing to bail out Lehman Brothers last weekend, the government is sending mixed signals. And there is a risk that the concept of "too big to fail" is giving financial institutions, automakers and perhaps others the idea that the federal government is some sort of corporate welfare agency.

David Leonhardt, writing in The New York Times on Tuesday, compared the current crisis in the financial system to the bailout of Chrysler Corp. in 1979. The reasoning then was strikingly similar to the arguments we're hearing today: Executives argued that Chrysler's failure would cause unacceptable damage to the American economy.

Though that buyout is still widely seen as successful (Chrysler survived, even thrived, for years), the companies, formerly known as the Big Three, learned from the experience that business as usual would be sufficient. Arguably, that allowed foreign competitors to eat their lunch.

What if Chrysler had been allowed to fail? As Leonhardt notes, some experts believe that the pieces would have been reconstituted into a smaller, nimbler company, which might have pressured the other domestic automakers to fix their chronic problems. Instead, they are back on Capitol Hill, hats in hand.

Perhaps AIG is a special case. Even if it is, the government needs to make it clear that the federal checkbook has limits.

Paul Kedrosky (via Economist's View) suggests the moral hazard argument (which the editorial board is using) is "overrated as an effect."

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