Nothing is too big to fail.¹

Sebastian Mallaby expands on Robert Samuelson’s mess from last week.

Surveying the world’s financial chaos, my colleague Robert J. Samuelson declared last week that “capitalism’s most dangerous enemies are capitalists.” This is the truth, but not the whole truth: There are constructive capitalists as well as dangerous ones. If election-year pressure for a clampdown on Wall Street starts rising, it will be vital not to lump the whole financial world together. A policy response has to distinguish between stabilizing players and destabilizing ones.

“Capitalism’s most dangerous enemies are capitalists” is not truth. Not the whole truth, not the partial truth. It has never been true. It will never be true. Capitalism’s most dangerous enemies are politicians.

Capitalists try to exploit the capitalist system through various techniques. Politicians try to exploit their own system by replacing capitalism with something else. Generally this is a form of centralized planning in specific, “important” areas of an economy. The argument is something like “We need food. We can’t trust people to understand that they need food without help from the government. Capitalism can’t provide it because it’s short-sighted.”

In more troubling cases, politicians attempt to subvert capitalism en masse and replace it with socialism. Our current election demonstrates this on both sides of the political divide.

Which group, capitalists or politicians, has a better chance at success in his chosen endeavor? In case you answered incorrectly, which group has the guns? Also, notice that Mr. Mallaby couldn’t make it out of the first paragraph before he argued for a policy response.

Stabilizing financial institutions have sensible incentives. People get paid to earn profits and manage risk at the same time. Despite how they are vilified, the majority of hedge funds are in this category.

Destabilizing financial institutions have skewed incentives. People discount risk and pursue profit recklessly because of their reward structure. Despite their reputation as the grown-ups in the system, the big investment banks suffer particularly from this skewing of incentives.

Ignore the big investment bank charge. It’s anecdotal to the larger point he is claiming. (It’s worth noting the critical nature of his questionable assumption that investment banks accurately knew the extent of the risk from a specific subset of recent subprime mortgages.) Destabilizing financial institutions (i.e. capitalists) mess up our economy. But nowhere does he note that capitalism’s response is to let those irresponsible, incompetent organizations die. The policy response is that any organization judged sufficiently important must be propped up.

Generally this involves taxpayer funding. Politicians deem the appearance of ability more vital than the presence of ability, as if this will solve the crisis. Also embedded in this irrational response is the belief that no other organization could or would immediately seize the portions of the deceased organizations business worth saving.

Essentially, if Apple went bankrupt tomorrow, politicians assume the portable music player would disappear from existence.

He concludes:

The right lesson from the turmoil is that banks must reward bankers who earn profits on a multi-year horizon. They must reform their incentives so that they become more like hedge funds. Politicians can call for this, and regulators can prod helpfully. But the banks’ big shareholders will have to drive the process. The rejuvenation of capitalism must come from the capitalists themselves.

Again, capitalism is as healthy today as it’s ever been. Even in failure by capitalists, capitalism hums along just fine, doing what it’s supposed to do. It’s the “calls” from politicians and the “prodding” from regulators – where do regulators get the authority to “prod” – that cause problems. Shareholders are excellent at figuring out that, if the risky² businesses they invest in are deemed essential to the economy, their investment will largely be bailed out. They’ll get a free shot (or shots) at redemption, courtesy of politicians and purchased by the coerced generosity of United States taxpayers.

Perhaps banks have bad incentives. But so do shareholders, when they know that capitalism capitalists can be manipulated by incentives from politicians.

¹ The United States government is included in nothing.

² Risky being merely a term to indicate that risk exists for every business. It assumes no assessment as to quantity of risk in any specific business, or how much or how little is acceptable.