Moral Hazard and Paul Krugman

Anyone who reads or knows me understands that I'm a Paul Krugman acolyte.  I don't get into hero-worship for anyone, mind you, but if I did, Krugman would be at the top of my list.   His blog is really convincing, and frankly I've never seen anything on the right that compares in terms of laying out an economics worldview, backed up with graphs and figures, but also well-written and with some fun snark.

So anyway, here he is on PBS talking about how Depressions or financial crises happen- he says that right after huge crises, things are crisis-free for a long time because people remember how bad it got, but that over time the memory fades and the reckless habits return.

Krugman's video is followed by a rebuttal by Russ Roberts.  Key quote:

But regulation is only one measure of government intervention. The last three decades saw government intervene relentlessly in financial markets to bail out creditors of large financial institutions making it easier to borrow money and finance imprudent risk-taking with other people's money.

He goes on to talk about the Moral Hazard problem, blaming our problems on past government actions in the 1980s and 1990s, bailing out large institutions that were deemed "too big to fail".  This created an implicit guarantee of government backing for reckless investing, encouraging inordinate risk-taking culminating in the real estate bubble and bust.

It's a fair point.  But I wonder what Roberts suggests at this moment in time to clean up this problem. To me, the trouble today is that these banks really are too big to fail, and if we let the financial industry go down next time this happens the result will be catastrophic for the US and world economies. Having seen the results, how can anyone seriously think that we should have let AIG and CitiBank go bankrupt after the Lehman fiasco? I'm all for protecting against the next crisis, but in this case the short-term pain would come close to killing the patient.

Keep in mind that it's really hard to make these incentives work. Remember that even though Lehman was permitted to fail, the traders who brought it down got really rich and already had their money. These guys are all mercenaries anyway, and I don't hear any talk of clawing back money or putting anyone in jail, so why would they care that they destroyed the company? Moral Hazard can be implemented pretty easily for the company, but not for the individual employees, and that's what matters.

That's why I'd rather see regulation of some kind to try to forestall the next crisis. Maybe it's limits on what the banks can do. Maybe it's a maximum size for banks, kind of like anti-trust laws. Maybe return to Glass-Steagall. I don't know, but it can't be status quo and wait for the disaster.

So I find it kind of mind-boggling that the policy of the Republican party is to repeal the Dodd-Frank financial reforms and replace them with..... nothing.  I guess in that sense Krugman is wrong about the memories of Depressions- Republican memories of financial disasters apparently only last about 6 months, or until the next election.