It's Their Own Fault, Right?

Listener Matthew Jastremski has a great question:

If the global "Pool of Money" made foolish investments in American housing, shouldn't *they* be the ones hurting?
If I lend someone with no income $500,000 and never get paid back, shouldn't I be held responsible for my own risk?
If a company lends thousands of incomeless people $500,000 each and never get paid back, isn't that their own fault?

Of course you're right. I would say pretty much everyone would agree that every investors, bank, hedge fund or whatever else that placed a bet on subprime housing should—by all logical and moral rights—be forced to pay the entire consequences of that decision.

Capitalism simply doesn't work when the makers of bad decisions don't pay the costs.

But ...

The problem is that so many big banks and other institutions made these stupid bets that if they were forced to bear the full pain of their bad decisions—as they really should—those banks and other institutions may no longer be able to fund the rest of us to do what we want to do. The whole system would break down.

This is a highly unusual case. In fact, it's never happened before.

To put it another way—echoing our guest Russ Roberts—all of those banks making bad decisions from 2003 to 2007 created a massive network of promises that many, many people took—excuse to the pun—to the bank.

Businesses were started and expanded, people bought homes and changed careers and bought cars and TVs and other things based on the promises made during that time.

The failure of all of those promises is forcing a disorderly and chaotic crisis throughout the economy that many people who did not make bad bets are being forced to pay for. How many of the hundreds of thousands of people laid off in the last month were subprime investors?

One thing is clear: whenever this episode ends, there will have to be a serious and real effort to prevent the growth of so many Too Big Too Fail institutions. We cannot have a functioning system if some don't pay the costs of their bad decisions. Not to be too grand, but our very way of life depends on that.

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