‘On Wall Street, the Great Recession didn’t last very long’
From an economic viewpoint, the most serious problem with the rescue programs was not that they further enriched the loathed bankers but that they exacerbated some serious incentive problems at the heart of the financial system. By extending trillions of dollars in loans, capital injections, and debt guarantees to troubled firms, the US government and its counterparts overseas had greatly extended the public safety net for banks and other financial entities. Left unchecked, this expansion will surely lead to more blowups, followed by even bigger bailouts.
The problem is one of rational irrationality. Once people in the financial sector come to believe that the government will cap their losses, they have an incentive to step up their risk-taking, what is called “moral hazard.” Simply announcing that there won’t be any more bailouts won’t solve the problem, a point noted by two Bank of England economists in an important paper published in November 2009. Policymakers may say “never again,” wrote Andrew Haldane and Piergiorgio Allesandri,
but the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.