Bear Stearns and the Moral Hazard

When the tide goes out, you get to see who's been swimming naked. --Warren Buffet

Conservatives of a certain school are found of speaking of the moral hazards of a welfare system. Living on government handouts creates a dependency, a servile status that weakens the human spirit. But the same conservatives often abandon this rhetoric when it comes to bailing out big business, a process that happens repeatedly. At this point, liberals chime in with “moral hazard” arguments of their own.

The problem with both of these arguments is that they are both true and both miss the point. Chronic welfare does indeed create a chronically servile population, and bailing out the rich does indeed create reckless behavior in the market. But isn't it a curious thing that both sides object, and object with objectively good arguments, yet both sides encourage the hazards, each in their own way? What is going on here? Why do we have situation to which nearly everyone objects and to which nearly everyone acquiesces?

Periodically, there are campaigns to limit the extent and generosity of the welfare system. The most recent “reforms” have reduced welfare and, in the process, have destroyed what little remained of the family structure of many poor people. Those who tout “family values” have made it impossible for families by forcing mothers into the labor market at subsistence levels. Still, one can understand the frustration people have with seeing large numbers of unemployed people living at taxpayers' expense. The campaigns to limit big-business welfare have been less successful, and when the irresponsibility of the rich puts the whole economy at risk, the government does not hesitate to act, and act in ways and amounts that dwarf the paltry sums given to the poor.

But if we look at the history of these questions, we find something rather remarkable: welfare, whether to families or businesses, is co-extensive with the capitalist system. Capitalism is the one system which has a fixed starting date, 1535. This is the date that the monastery lands (and later the guild lands) were seized by the British Crown and transferred to private owners, usually for pennies on the pound, immediately creating a new class of capitalists with decisive power over economic and political affairs. One of the immediate results was a collapse of wages and a huge increase in crushing poverty. In order to prevent social chaos, it was necessary to establish the “Poor Laws,” the foundation and prototype of modern welfare systems. At the same time, the Capitalist system, which begins with an act of government violence against traditional rights, sustains itself only by granting greater and greater privileges and subsidies to the rich. Indeed, by 1776, Adam Smith devotes 3/4^ths of the Wealth of Nations to documenting, in excruciating detail, the amount of subsidy and privilege given to the “mercantile” class.

There was an attempt to reform the system. In 1832, the liberal party gains control of England and attempts to impose a laissez-faire system of pure capitalism. These efforts continue until the long depression of the 1870's, and collapse entirely with the Great Depression of the 1930's. Since the Second World War, capitalism has achieved a fair degree of stability by a combination of welfare systems, one for the rich and one for the poor. But that system itself may now be on the verge of collapse. We are coming to the point where the moral hazards, on both sides, outweigh the financial benefits, benefits which are evaporating before our eyes. But this is not news, but the entire history of capitalism, a system that has never been able to stabilize itself (see Does Capitalism Work?) Indeed, all attempts to return to the purity of laissez-faire have resulted in the opposite: a growth in government power and debt (see Hayek's Super-Highway).

The dual problem of capitalism was noted by Hilaire Belloc in The Servile State. Capitalism creates uncertainty for both workers and investors. The former lose all bargaining power in the matter of wages, while for the latter, competitive anarchy imposes unacceptable risks. The result is a compromise, the Servile State, which guarentees both sides, more or less. This is system is the opposite of capitalism and the essence of oligarchy. Thus capitalism, a system that claims to be based in liberty, inevitably leads to its opposite, servility on one hand, and aristocratic privilege on the other.

Which brings us to Bear Stearns. Ben Bernanke has received any amount of criticism for bailing them out, but in fact he is just doing his job, and the system would collapse if he did not. It may collapse anyway, but at least he has bought some time to see if there is a way out. Up until now, there always has been a way out, more or less. When something has threatened the system, the government has stepped in to bail out the miscreants. The list of bailouts is impressive: Long-Term Capital Management, the Chrysler Corporation, the Savings and Loan banks, etc. So how do these institutions become so important that their health is a matter of concern to the government?

In the case of Bear Stearns, the Fed reasoned that its failure would presage a failure in the entire credit system, and they were likely correct in that judgment. To take just one area, derivatives, BSC was carrying derivatives with a notional value of $15 Trillion. That's “trillion,” with a “T”. That's more than the entire GDP of the United States of America. Of course, the notional amounts do not represent the actual amount of risk; a derivative links its holder to the risks and rewards of owning an underlying financial instrument without actually owning the financial instrument. Holders of derivatives are betting on small changes in the value of some underlying asset which they do not actually own. Notional amounts are more a measure of the extent of risk rather than the amount; you get such large numbers because a large number of investors are placing bets on the same underlying assets. The actual amount at risk may be only a tiny fraction of the $15 Trillion, but it is a risk which spreads through the entire system. Now, consider that the entire derivatives market exceed $500 Trillion. A failure in one dealer might collapse the whole market. Now, add to that the holdings in sub-primes and other risky instruments, and it is not hard to envision a failure in BSC leading to a failure in the economy. BSC cannot cover their risks; they are “swimming naked,” to use Warren Buffet's colorful term. Therefore it is necessary to “socialize” their risks, which is a fancy way of saying, “let the taxpayer take the risk,” which is to say, “Socialism for the Rich.”

Capitalism has always led to its opposite: socialism for the rich and servility for the poor. This is its entire history. It cannot sustain itself without the combination of socialism and servility. It is itself a moral hazard, and there is simply no use for either side to complain about what is an historical fact.