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Leonhardt on Looting

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David Leonhardt [2] (HT: Arnold Kling [3]) finds a fascinating paper by Akerlof and Romer [4] from 1994 called "Looting." It's an analysis of the moral hazard problem that results when too many financial institutions are considered too big too fail. I will read the original article but in the meanwhile, Leonhardt's summary is well worth reading and consistent with Allan Meltzer's claim [5] (start listening around the 42 minute mark). One highlight from Leonhardt:

The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Promised
bailouts mean that anyone lending money to Wall Street — ranging from
small-time savers like you and me to the Chinese government — doesn’t
have to worry about losing that money. The United States Treasury [6] (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.

But
the knowledge among lenders that their money will ultimately be
returned, no matter what, clearly brings a terrible downside. It keeps
the lenders from asking tough questions about how their money is being
used. Looters — savings and loans [7] and Texas developers in the 1980s; the American International Group [8], Citigroup [9], Fannie Mae [10] and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.

Do you remember the mea culpa that Alan Greenspan [11], Mr. Bernanke’s predecessor, delivered [12]
on Capitol Hill last fall? He said that he was “in a state of shocked
disbelief” that “the self-interest” of Wall Street bankers hadn’t
prevented this mess.

He shouldn’t have been. The looting theory
explains why his laissez-faire theory didn’t hold up. The bankers were
acting in their self-interest, after all.

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