I know that the time isn’t right for this yet but I want to prep the conversation for whether or not bailouts as a general policy aren’t simply a good idea.

The obvious retort is that it just encourages risk taking. The question, however, is – are we certain that that is a bad thing?

Take TARP. The bank portion of TARP made a profit. However, some people fear that it only encouraged banks to take risks in the future. However, if in the future we bailout more banks and earn additional profits, are we sure this is necessarily a bad arrangement?

The gut reaction is that risk is bad and of course risk taking is unpleasant for most people. However, risk-taking is also the foundation for growth. Taking calculated risks is a social good and produces externalities.

Thus in the aggregate we should expect the problem society faces is not that people take too many risks but that they take too few. In such a case, subsidizing risk taking is exactly the right thing to do.

Now, at the same time there was a massive recession in spite of TARP. This is why the question of whether a more powerful monetary response could have beaten back the recession is so important.

I think monetary policy failed us this time around, but I think it failed for predictable reasons. We were too close to zero lower bound, we did not have price level targeting and there was widespread resistance to quantitative monetary policy. These conditions make a large drop in aggregate demand from any source dangerous.

I would suggest that a higher baseline level of inflation combined with some form of level targeting – I am open to NGDP or nominal spending – would have allowed the Fed to keep its winning streak.

If we have a means of stopping a wide spread bank panic and we have a means of stopping a general recession then we effectively have means of neutralizing the downside risks from financial implosions.

This may sound like unhinged purely academic musings but we do this all of the time. The most obvious example is the FDIC, which provides regular bailouts to depositors of commercial banks and for the most part has been extremely successful.

Even more fundamentally we regularly bailout actual fires. Fire spreading from one building to the next is a danger in a packed city and we could require that people build further apart to prevent this externality. However, density also offers enormous positive externalities.

We handle these dueling externalities by allowing very dense buildings and then employing a public fire department to cover the increase in fire risk. Most people have found this relationship highly advantageous.

So in the same way that we regularly bailout home fires, it might be in our interest to regularly bailout economic risk takers of various stripes. The core question is how important is risk taking to our economic system. I tend to think “extremely” but there is much more debate to be had.

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