Adam Smith, the godfather of free-market thinking, once wrote this on the topic of regulating banks:
[E]xertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which [he] proposed.
The idea here is simple. You, or any company, should be able to take whatever risks you wish, and face whatever consequences come from it. But once your risks have the potential to hurt me, someone has to call a time out. Eat unhealthy foods in your backyard, fine. Build a homemade nuclear reactor in your backyard, not fine.
Through all the hysteria, the 2008 bank bailouts followed this idea. No one cared if AIG's (NYSE:AIG) shareholders lost their shirts -- indeed, they did. The danger was that AIG's collapse would spread throughout the economy, harming those who had never done business with the insurer. The banking system is so interconnected that the chain of events is straightforward: A major bank or insurer fails, credit markets seize up, the commercial paper market shuts down, and suddenly the majority of U.S. businesses that utilize short-term credit are up in the air.
Earlier this month I sat down with Joseph Stiglitz, the Nobel Prize-winning economist. Here's how he responded to the notion that financial risk is contained to those who voluntarily take it. (A transcript follows.)
Joseph Stiglitz: Even if they know the risk that they face, they don't understand the systemic risk to which they expose our entire system. They didn't understand that when they were dealing with AIG, they were putting at risk the entire financial system. And that, $150, $180 billion bailout to one company. That's an amazing amount that went to one company. Did they take that into account? I don't think so.
Let me give you another example of you might say systemic risk. This time in Europe, when Greece needed to restructure their debt, the question was, what would be the fallout? It was clear they needed to restructure their debt. If they didn't, they would not be financially viable. But no one knew who would bear the consequences because everybody had CDSes with everybody else, totally non-transparent. Even their regulator, European Central Bank, didn't know what the fallout would be. So when you have lack of transparency, you get hamstrung. You can't run policy.