The threat of “systemic failure” has been used to justify recent government interventions in the financial sector. Essentially it is a “market-failure” type of argument – that bank failures and their repercussions impose huge “external costs” on the wider economy. Failure in the market, a perfectly normal, healthy experience, has therefore not been allowed by the authorities during the credit crisis.
There is a strong argument that the importance given to the threat “systemic failure” by policymakers owes more to interest group politics than economic fundamentals.
Indeed, this very dangerous fear has been put about by the banks themselves to justify almost any bailout by governments of the financial system. In particular it has been used by the investment banks to address the risk of their weaker counterparties failing, like AIG, who the more “successful” banks rely on to pay up their trading and numerous other losses, and thus pay the trading “gains” and other “revenues” apparently won by the investment banks.
In reality, the “good” investment banks should not have been trading with these weak players as they could not really pay their debts, i.e. they were far less creditworthy than they appeared. In their defence, the “good” investment banks knew that most of the “weaker” players were in some way or other implicitly guaranteed by governments and, disastrously for the taxpayer, these “good” investment banks have been proven right, so far. The investment banks and their lobbying machines have so frightened the politicians and the public with fear of “systemic risk” that they are now able to carry on the game regardless of the recent experiences.
At an event I attended, a very senior banker at one of the largest US investment banks actually bragged about how they were too big to fail given their “crucial” position in forex, interest rate and credit derivatives markets. It was a very ugly moment, but one that brought home to me how important it is to challenge these banks and those that fall for their propaganda in government, the financial media and academia. I don’t think Timothy Geithner is a bad guy – he is a highly competent administrator – but just sadly mistaken and actively misled by the investment bankers who surround him.
We have to free ourselves from fear of failure and free ourselves from the scaremongering by banks and the financial markets generally, one of the biggest and most successful special interest groups of modern times.