Too big to fail is a government invention

There is no reason for anyone other than the owners (that is, shareholders) of JP Morgan to care one bit about the losses at the bank.

But, as usual, Mr. President has inserted himself into the situation, by saying:

Obama questioned whether a weaker bank might have required government help in the same circumstances. That’s why Wall Street reform is so important, he said.

There are so many hidden assumptions in that one snippet that it's worth going through them.

Obama assumes: Weaker banks need government help to stay in business.

Bogus. Badly managed banks whose fates depend on everything always going to plan ought to go bust.

The government must not, either implicitly or explicitly, insure the customers of banks because doing so removes the incentive to pay attention to where they're putting their money.

The government must not, implicitly or explicitly, insure lenders to banks because doing so is the same as insuring my loan to the friendly neighborhood crack dealer.

The government must not, either implicitly or explicitly, insure shareholders of banks because doing so means the owners do not monitor the employees adequately during good times leading to bad outcomes when one little thing goes wrong.

The government and the federal reserve must be able to step in, and facilitate orderly dismantling of banks and other financial institutions, but do it according to a pre-established set of principled rules, not in the ad hoc manner in which Bernanke, Paulson, and Geithner handled the 2008 crises.

Obama assumes: Congress can set rules, and bureaucrats can apply such rules, so that no bank ever goes bust.

Creating the impression that mistakes and losses are somehow an aberration to the functioning of a free market economy, and the expectation that somehow the government can make the consequences of every stupid action is more dangerous than any derivatives trade any quant can play with.

Neither politicians nor bureaucrats are capable enough to understand, let along play, the games played in financial markets. The more rules there are, the more profitable it is to find ways they can be exploited in unintended ways while enjoying the insurance provided by the rest of us.

This is a charade. There is nothing wrong with trying to take advantage of modern financial tools. What makes the situation potentially catastrophic is the message that government consistently sends to customers, lenders, and shareholders of these financial institutions: Do anything you want. We'll make sure to confiscate other citizens' livelihoods to save your bottom.

Too big to fail, therefore, is a political invention. It can only be useful to politicians and their buddies so long as you believe in the boogeymen with which the politicians are trying to scare you. You might have to brace for impact occasionally, but the world won't end if big banks declare bankruptcy or if some borrowers have to move from their fancy houses to rental apartments.

The politicians will only be able to keep on exploiting us if we believe them when they yell "fire" in a crowded theater.