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By James Kwak

Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.

I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.

Cowen also has an accurate read of the current situation:

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns.

Or, there’s an implicit expectation that creditors of large financial institutions will be protected, but that expectation periodically wears off and has to be bolstered by some confidence-boosting measure, but that measure can never be an explicit guarantee . . . and so on.

Cowen has some suggestions for how to fix this problem in future regulation. But what should we do right now? As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.

Source: Creditors Should Suffer Too