Consider the following game:
From a standard deck of fifty-two playing cards along with two jokers, I let you pick a card. If the card is a spade, heart, diamond, or club, you receive $20,000. If the card is one of the jokers, you lose $1,000,000. Would you play the game?
Unless you are a fool, you wouldn't. After drawing the entire deck, you would be out $960,000.
Now let's change the game:
You draw cards from the same deck. You still get $20,000 every time you draw a spade, heart, diamond, or club. Now, however, when you draw a joker, you lose half of what you have made up until that point and some unknown innocent party loses $1,000,000. Would you play that game?
If you had some sense of ethics, you might not, however, if you were a Wall Street trader or executive, you would play all day long.
In a Wall Street Journal Op-Ed today and frequent spots on CNBC, Charlie Gasparino claimed to have identified the cause of the financial crisis. Anyone who is familiar with those two fonts of wisdom won't be surprised to learn that it wasn't the over-compensated traders and executives on Wall Street who took irrational risks. It was...brace yourself...the government! Specifically, it was the government leading those risks takers to believe that they would get bailed out if their bets went sour and that same government encouraging undeserving peons to believe that home ownership was a right. I will only try to address Charlie's first reason for blaming the government in this post.
The problem with Gasparino's "moral hazard" thesis is that the traders and executives who worked for companies that got bailed out didn't do any better than the ones who worked for companies that didn't get bailed out. Think about it. Bear Stearns got bailed out and Lehman Brothers didn't. However, both Jimmy Cayne and Dick Fuld took a bath on their holdings in company stock as did all the traders and executives in those companies. Moreover, traders and executives in both companies lost their jobs. If the potential for a government bailout played a role in the risks they took on behalf of their companies, why didn't the bailed out executives come out way ahead?
The reason is that the risk that Wall Street traders take is driven by the nature of their compensation packages, not by the possibility of bailouts. Like players in the second game I described, Wall Street executives get paid generously if their bets work out and they have to give up part of what they made if things blow up in their faces. However, it doesn't matter to the executives and traders who takes the loss when they draw the joker. If their company is bailed out, it is the taxpayer. If it is allowed to fail, it is their company's lenders, customers, and counter-parties that take the hit. The executives and traders are indifferent between the two. They will take the risks they do as long as the losses fall somewhere else and that is a function of the manner in which they are compensated, not the extent to which the government backstops the market.