The Fairness of Financial Rescue

Financial bailouts are understandably controversial, because they reward those who bet on risky assets. But a policy that leaves owners of risky financial assets impoverished is a policy that shuts down dynamism in the real economy.

BERKELEY – Perhaps the best way to view a financial crisis is to look at it as a collapse in the risk tolerance of investors in private financial markets. Maybe the collapse stems from lousy internal controls in financial firms that, swaddled by implicit government guarantees, lavish their employees with enormous rewards for risky behavior. Or perhaps a long run of good fortune has left the financial market dominated by cockeyed optimists, who have finally figured that out. Or perhaps it stems simply from unreasoning panic.

Whatever the cause, when the risk tolerance of the market crashes, so do prices of risky financial assets. Everybody knows that there are immense unrealized losses in financial assets, but no one is sure that they know where those losses are. To buy – or even to hold – risky assets in such a situation is a recipe for financial disaster. So is buying or holding equity in firms that may be holding risky assets, regardless of how “safe” a firm’s stock was previously thought to be.

This crash in prices of risky financial assets would not overly concern the rest of us were it not for the havoc that it has wrought on the price system, which is sending a peculiar message to the real economy. The price system is saying: shut down risky production activities and don’t undertake any new activities that might be risky.

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