Nice polemical essay on the sub-prime crisis by Tony Curzon Price…

In a system-wide crisis, no one wants to trade. There is no price at which anyone can be convinced to hold a contract, because no one knows what its value is. In this circumstance, a fund manager is a helmsman in a storm: aware of every danger of his position but powerless as wind, then waves, batter him here, then there. But unlike the helmsman, the storm is made worse if another ship in the vicinity goes down. If a bank actually faces bankruptcy, all the contracts and obligations held by that institution will be bad, thus infecting trust in every part of the financial system.

The central banks bail out the funds in order to stop anyone seeing a ship go down, as a way of stemming contagion. That is the defence. This is why we, as citizens and voters the owners of the central banks, lend money in conditions in which no banker would lend. And the argument is strong: contagion and system-wide crisis will have a real impact that will cause hardship: when firms and households find borrowing is hard, demand drops, jobs go … recession. There is a real case here for us to bail the hedge-funds.

But the metaphor of the storm is misleading. Meteorology is not caused – at least not predictably – by the decisions of the helmsmen it affects. Financial crises are. It is because we can be counted on to be lenders of last resort that traders and managers can discount the risks of system-failure and therefore behave imprudently with increasing ease and frequency. The pattern is familiar from the libertarian critique of welfarism: while a safety-net for the deserving poor is good, the existence of the safety-net will create a class of idle, undeserving scroungers. It is hard to be good without encouraging others to be vicious.

Fund managers have been enjoying a one-way bet for six years or more. A credit-worthy institution could borrow very cheaply and lend on without any concern about becoming systematically over-stretched. In the extreme case, the Japanese central bank has been lending money almost for free. Those with access to free money could lend it on to those without such privilege and pocket not just the difference, but, through gambles, multiples of the difference…