Crocodilian

What Do We Need In 2009? More Failure

"But Bailout Nation doesn't believe in failure so much anymore."

Not clear that that is a true statement. We've had lots of corporate bankruptcies, but our system has assumed system-wide leverage that was not ready for a severe stress. Add to that, the painful reality is that we don't have the systemic resources to process a major failure -- say, a GMAC or WAMU.

If you want to "make room for failure" in the system, the system architecture needs to be robust. Venture backed firms go bust all the time; but they are funded with equity, not debt, and nothing much bad happens when a startup become a shutdown. Paradoxically, we give significant tax incentives to debt (which is payable out of pre-tax income) over equity (which pays dividends out of after tax income); we should not be surprised that a whole financial industry developed to replace equity with debt. More equity and less debt would leave us more room to let things fail.

Second, financial institutions have to be designed to, as software architects say, "degrade gracefully". Institutions like the investment banks degraded catastrophically-- pull one thread, somewhere in the system, and they rapidly fail. Not only do they fail, but as we saw with Lehman Brothers, they fail in a way that threatens to force the failure of their entire web of business counterparties.

Third, there should never again be such a thing as an "implicit guarantee"; obligations need to go on the books as explicit, or stay off the books and be disclaimed. The bizarre chimera structure of the GSE's was a most pernicious contributor to a system that was ambivalent about failure.