Thursday, March 19, 2009

Looting 2.0 (Or, Why AIG Must Fail)

Looting 2.0 (Or, Why AIG Must Fail)

7:43 PM Tuesday March 17, 2009

Looting tomorrow's wealth for today is the addiction Capitalism 1.0 can't kick. And that's why we should let AIG fail.

The story goes like this.

Banks essentially bought insurance from AIG. A well-known phenomenon in insurance markets is adverse selection. When information is poor, or transaction costs are steep, those with the highest risk of loss are more likely to buy (and more likely to buy larger amounts of) insurance.

Conversely — and intuitively — insurance can amplify risk-seeking, especially in the presence of disproportional losses. And even more so when the losses in question are shared by society — where the result is a huge asymmetry in outcomes. A positive outcome results in private benefits, but a negative outcome results in public losses.

Let's put that another way.

The presence of insurance when outcomes are asymmetrical massively dilutes incentives to act responsibly. The incentives that result are: heads, I win; tails, I still win. If I win a bet where costs might be imposed on everyone, I gain, and no one else does. If I lose a bet where costs might be imposed on everyone, everyone pays off my losses but me. That's looting — the subject and title of a classic paper by Romer and Akerlof, recently highlighted in the NYT's Economix blog.

Looting doesn't just happen because governments insure banks. Romer and Akerlof's paper posits that bailouts create incentives for looting, by insuring bankers against losses. It's a very elegant model — but it has one flaw. The only source of insurance that fuels looting isn't just the government: AIG did a great job as well.

The point: there will be no incentive for banks to act responsibly now or in the future if a mega-insurer is setting the stage for adverse mega-selection. And that's why AIG must fail.

If a mega-insurer that isn't the government exists, what happens? Mega-looting. Let's take the argument further. The government will pick up the pieces after bankers loot banks. Yet, bankers are constrained in their ability to loot by the amount of deposits they can take in directly.

But here's a big, fat wrinkle. If there's a mega-insurer around willing to explicitly insure them before they go bust — well, then the sky's the limit. Every bank can and will lend to and leverage every other bank, amplifying how much loot each takes in. Sound familiar? It should: it's the story of the last decade. So without letting AIG fail, mega-looting is wired into the DNA of the banking sector.

We don't need to bail out banks: we need to bail society out of a broken "banking" system in which the incentives to mega-loot dominate the incentives to bank. Money is flowing straight from taxpayers directly to AIG's counterparties. Yet, without the structural change of AIG not insuring their disproportionately risky behaviour anymore, nothing will change. Propping up this toxic system is an act of economic violence, intellectual dishonesty, and moral bankruptcy.

Bailing out AIG's looters is worse than crony capitalism — it's crony socialism. Your money's being transferred directly to — let's see, who's at the top of AIG's counterparty list? Why, it's none other than Goldman Sachs, who, just a few months ago vehemently denied any significant exposure to AIG.

Goldman, is, of course, Hank Paulson's former employer, and apparently the home of one of Tim Geithner's most influential mentors.

Wow, what a surprise. Socialism for the rich, capitalism for the poor.

It's time for a better kind of economy, based on a more constructive kind of capitalism. Capitalism 1.0 has produced systemic crises of exploitation, conflict, stagnation, and nihilism across industries. Looting is just a financial subset of these.

After all — banks only looted their depositors. But Corporate America has been busy looting our environment, communities, health, and happiness for decades.