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What Happens If We Let the Financial System Collapse?

By Morgan Housel - Apr 21, 2013 at 10:16PM

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Joseph Stiglitz on the economy.

Some wish that we were tougher on Wall Street in 2008. AIG (AIG -0.69%) shareholders were almost wiped out. AIG bondholders didn't get touched. That was dangerous. Bondholders should have taken a hit, they say.

Others counter that making bondholders take a hit would cause a virtual bank run on the financial system. Indeed, there's good precedent for that after Lehman Brothers went bankrupt.

I asked Joseph Stiglitz, the Nobel prize-winning economist, to reconcile the two opinions. Here's what he had to say (transcript follows).

Morgan Housel: When I think back to 2008, one example I think of is the Reserve Primary Money Market Fund. It owned some Lehman Brothers' debt. Lehman Brothers went bankrupt, and it caused a run on the money market fund, as Reserve Primary broke the book, which instantly overnight caused the corporate credit paper market to freeze up, which had real-world impacts on growth restorers and automakers. So it does seem like 2008 did give us examples of a bank run on debt that had real-world consequences.

Joseph Stiglitz: Yeah, now that's a very interesting example. That illustrates the doctrine that was prevalent before the crisis, that you could allow the shadow banking system to go on and that it didn't represent any systemic risk and therefore we didn't have to closely regulate it. That doctrine was wrong. And so going forward, we are now in a position to realize how wrong we were. We need to regulate the shadow banking system so exactly the kind of thing that you described doesn't occur.

But even then, the issue was we could have protected the depositors in the shadow banking system without throwing so much money at the bankers or the shareholder and the bondholders; let's target the money where we needed to target the money to keep the flow of credit going. The irony in all this was we said we were doing this to keep the flow of credit going, and in the end, we did it in such a way that we didn't put any pressure on the banks to maintain the flow of credit, and too many of them didn't do that.

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