I do not agree with the US government’s decision to bail-out AIG but I do understand why they did it. If AIG had been allowed to fail it would not have been able to honour the large number of CDS and CDO contracts that it had written, which could have resulted in the failure of many financial institutions that stood on the other side of those contracts and might have even led to the failure of financial system as a whole.
The banks that would have taken losses had AIG been allowed to fail may have learnt from their mistakes and perhaps would have become more careful about taking these or other risks. Or they may have not – I don’t know. However, if AIG had failed, I would really have great confidence in the surviving banks’ ability to manage risk.
This is in fact the essence and strength of capitalism. In good times (almost) everyone makes money. However in a downturn, the strongest survive, whilst the weakest go bankrupt or are taken over or suffer losses and have to adapt. This means that the companies that emerge are stronger, or at least fitter to survive the new economic environment. Similarly the system as a whole gets stronger from the failure of the weakest elements. This process is not like an evolutionary process, it is an evolutionary process. And that is why capitalist systems are generally resilient and robust.
But when governments intervene they undermine this process – the individual circumstance of every bailout may be entirely justifiable and understandable, but the cumulative impact is to undermine the resilience of the system as a whole. We are familiar with the result: it is the zombie banks of Japan and Europe, the car companies of Britain in the 1970s and the big auto manufacturers of the US rust belt. All of these companies depend for their existence on government handouts. And, just like people who depend on handouts, they quickly evolve a dependency culture from which they can never escape. Worse, every time the financial system is bailed out, through direct intervention such as AIG or LTCM, through low interest rates, through quantitative easing, or from any other means, it too becomes less resilient and more likely to fail.
So next time a bailout situation arises, the government in question will look at AIG and think ‘well that worked out alright’ and will be a little less reluctant to take the plunge. We are well on the way down the road to zombiedom.