Bailing Out?

Hi all,

so yesterday Krugman had a thought provoking analysis of the whole bailout / moral hazard issue involved in the subprime crisis, arguing that in the US a taxpayer funded bailout of the financial system is as good as inevitable. And it got me thinking - how can we prevent these kinds of financial meltdowns, which in the end have a huge opportunity cost borne by society as a whole, from happening in the first place?

I mean, every 10 or 20 years or so, it seems as if financial markets suffer from a collective amnesia, whereby they forget how bad things were as a result of the last crisis (e.g. the US Savings and Loans Crisis in the 1980s), and go absolutely nuts in the chase for the easy buck. This, combined with their apparent belief during these episodes that the laws of financial gravity have been suspended - that returns can only go to heaven and that the good times will roll forever - seems to be a recurring recipe for disaster.

Whose fault is it - the shonky financial analysts and brokers who recommend / trade these dodgy products? I mean, obviously not all financial analysts and brokers are wheeling and dealing, but there must be at least a 'few bad apples'. For an example of 'brilliant' financial advice, check out this gem from CNBC stock analyst Jim Cramer in relation to Bear Stearns:




.........and if you missed Cramer going crazy about Bear Sterns and the role of the Fed / Bernanke last year, you can catch it here:



Or is it the fault of policymakers, who create an environment full of perverse incentives, within which these kinds of activities are allowed to flourish? If this is the case, how can we better align incentives to reduce the opportunity for this kind of thing to occur? And surely there is also some kind of responsibility to fully disclose to consumers the insane risks involved in getting mixed up in these dicey deals, that there is a good chance that they could endup on the street when things turn bad?

Or do we simply accept that financial meltdowns are a periodic fact of life and necessary in order to shakeout the markets, episodes of 'creative destruction' a la Schumpeter?

Krugman in his article makes the obvious point that a public bailout is of course preferable than the alternative of standing idly by and watching the financial system implode. But given that prevention has to be better than the cure, surely there has to be a better way to deal with financial meltdowns than simply having the public pick up the tab at the end, when there are plenty more productive uses that the money could be put towards.

Thoughts anyone?

Cam.