MORAL HAZARD.

There's some concern that the government's bailout of AIG (and everyone else who isn't Lehmann Brothers) is disrupting the moderating threat of "moral hazard" on Wall Street. As the idea goes, the government's containment actions will ensure that Wall Street takes these risks again, secure that the Feds will clean up any mess they make. Alas, their may be a kernel of truth to that. But I basically agree with Paul Kedrosky when he says this is an example of economics-types taking theory too far into reality:

I wish people would shut up about "moral hazard". Yes, bridging AIG through its current crisis is not something you want to do; and yes, it would be better if the market solved its own problem. But even a cursory analysts of the serpentine connections between AIG and capital markets tells you that the latter just can't happen, so you have to hold your nose, be an adult, and live with the former.Moral hazard, while real sometimes and in some places, is vastly overrated as an effect. Granted, it's seductive in the same way that risk homeostasis is -- the notion that, for example, people drive faster and take more risks because they have seatbelts -- but like risk homeostasis, moral hazard is vastly over-diagnosed. People at major financial services outfits don't project five years into the future and say, "Lever up, boys and girls. We'll either make a lot of money now, or be bailed out later." Real people in real markets don't think that way. Matter of fact, if anything, they're short-sighted in that regard to a fault.

Plus, the lessons of the bailouts are complicated, in part because of the Federal Reserve's inconsistency. Do you end up like Bear-Stearns with a total rescue? Like Lehmann Brothers, with total liquidation? Like AIG, with government ownership and an $85 billion loan that has to be paid back at credit card rates? Are you one of the executives who loses their jobs, one of the workers whose department is closed down when the assets are shed, or one of the few who escape unscathed?And then, on the other side, are you Bank of America, who was subject to regulatory oversight and didn't get caught with a heap of highly leveraged junk investments, and now sees their prudence repaid many times over because they're acquiring failed institutions for a song? People don't want their businesses to fail. And even if all they feared were personal consequences, there's such an array of outcomes on the table that it would be extremely hard to predict which would befall you. Which is all to say, I'm not too worried about moral hazard here. But that doesn't mean there shouldn't be consequences: I'd start with an immediate push to equalize the tax treatment of incomes derived from private investment. It's an odd quirk of the tax system that simply treating income as income will be judged a punishment, but so be it. These guys have lost any public sympathy they ever had and sacrificed their ability to claim that they're taking advantage of lenient tax treatment to create value for the rest of us. Close the loophole.