Appraising Risks to Growth: AIG Should Have Failed

No.: 
48

The U.S. Congress ought to blush about the AIG situation as should Fed Chair Bernanke. The amount of money spent defending AIG’s bad bets is incredible. But there is something else at stake here. At issue is the question of whether the government knows what it is doing. People need evidence that the Fed and U.S. Treasury are operating a “best practices” recovery plan. The continuing infusions of capital into AIG warn observers that government continues to be confused about priorities that make sense in our times. Instead of allowing the market to right-size the economy by reshaping the financial sector to something that is sustainable, the government tries to save the debt environment by keeping on life support various private entities that played duplicitous roles in the easy money growth paradigm.

No corporation is more guilty of an indefensible business model than AIG; thus, no corporation is less worthy of governmental assistance. Those who champion the bailouts claim that the existing financial architecture will fail without continued intervention. Well, fail it should! It is an evolved architecture subject to exploitation by elites and ought to be replaced by something more worthy to be called honorable capitalism.

Taxpayers should not be responsible to support businesses predicated on faulty assumptions. The AIG model propagated unsustainable revenue devices. Instead of propping up and subsidizing the irretrievably flawed AIG system, the Bush administration should have used its pre-emptive intervention to bust the corporation asunder. Had it done so, we would not be throwing good money after bad. AIG’s legitimate interests should have been quickly severed from defective ones, with government distributing the legitimate pieces to sound competitive enterprises in America but off Wall Street.

AIG and its competitors priced enterprise revenue insurance on the unsustainable assumption that Wall Street’s growing derivative universe would forestall any systemic economic correction of consequence. It was postulated that individual business policies could be written without regard to aggregated economic history because macro-risk died with the advent of a new calculus. And what was that calculus? It was nothing more than a dog chasing its tail — an expression of circular reasoning concocted by the same types of people who made the stock market look like a Ponzi scheme.

Emboldened by the defacto religion of Wall Street where money chases money, AIG aimed at curing market risks by shifting risk to insurance, then priced that risk insurance on a bizarrely unsustainable basis. Naturally, this had the effect of concealing risk and heightening rather than mitigating it. To declare the AIG business model a financial sophism would be an understatement. The fact that government regulators countenanced this moronic strategy is beyond comprehension and an indictment of the existing regulatory system.

AIG priced its business of backstopping commercial credit and business solvency on the reprehensible supposition that a debt based economy could expand indefinitely. This negligent assumption turned reckless when AIG pursued the business with an aggressiveness uncorrelated with its backstop assets. But AIG executives did not care. All they wanted was big payout in salaries, commissions and bonuses. In case of an economic calamity, their failures would become someone else’s problems. By analogy, it was as though AIG wrote life insurance on the assumption that people don’t die — underwriters just keep on collecting premium with little administrative overhead. In its greed AIG sought profits not hemmed in by legitimate actuarial calculations. The low regulation environment made possible the AIG bet that the last economic calamity the world would see happened in the early 1930s.

Now we’re in the midst of a catastrophic economic event and predictably so. While the timing and exact nature of the debacle was not subject to forecasting, the reversal became a certainty as debt reliance in all sectors — government, consumer, mortgage and business — expanded in the 1990s and beyond. Debt expanded because money became cheap. Money became cheap because corporations like AIG played a sham game of offloading corporate debt risk onto insurance balance sheets that were not sustainable. With the ludicrous nature of that proposition now evident, money should become more expensive. The cost of money should reflect real world hazards as well as ecological costs. But the U.S. government is fighting tooth and toenail to prevent money from being priced realistically because the Republican party wants the nation to borrow its way out of the debt hole (go figure) and Democrats want government to do and spend everything that government does not do or spend well. No wonder taxpayers shudder as the government keeps dishing AIG more money.

We’ve fallen through the proverbial rabbit hole into Wonderland and much of what we see now looks insane. This is no way to run a country let alone a rabbit hole. AIG set its corporate mind on short term plunder. That’s why AIG should have been swept out of this economy like manure being swept out of a barn. But there are bigger issues. AIG’s ongoing federal subsidy is coming to symbolize that the U.S. government is in a state of denial about the sustainable size of the U.S. economy. The simple fact is that money must become more expensive if the U.S. dollar is to be defended against other currencies once the new panic about the sustainability of other countries’ debts is priced in. Likewise, money must become more expensive once ala carte and aggregate business risk is priced defensibly (which AIG failed to do). The cost of money must grow once the U.S. taxpayer realizes that it is not the taxpayers’ responsibility to backstop Wall Street’s excesses. This is not to argue that expensive money is ideal; merely, that inappropriately cheap money necessitates expensive money as a cure to the rot that illegitimate money brings.

The prospect of increasingly expensive money means that the government should shift to a ‘pay-as-you-go’ model. But this is exactly what the major political parties do not want because they fear high unemployment would end their franchise just as surely as it would bring the current Chinese regime to an end. Thus, the U.S. government will continue doing everything in its power to keep money cheap so that it can borrow tons of it and keep people in their homes and jobs. The government’s continuing support of AIG is just one more expression of governmental resistence to right-sizing the economy.

In the final analysis, Bernanke and company may know what they’re doing if the goal is to provide a defense of the debt-driven model of growth economics. Maybe the bank of Benanke will win the current struggle as central banking migrates to the center of the political universe. Nevertheless, many Americans doubt that this is the right battle for our times since it fights for something unsustainable and dangerous. The better pathway would be to let the financial sector shrink massively while putting the people who get laid off back to work building a green economy. Paradigm shifts involve pain but at least the money would be expended to create a new world rather than reviving one that has become irreparably unjust, and inefficient because of injustice.