Cross-posted in my Daily Kos diary, where it will be almost certainly ignored (because kossacks mainly care about breaking news).

A Metaphor

Suppose I had a car company, Woodside Cars, Inc., and we discovered an amazing new way to power cars using a miraculous substance called unobtanium. We'd roll out a line of new cars, and everyone would buy them, because they never have to be filled up. People would buy shares in the company too. The cars are great, they're well made, they save money, and have a high resale value. But then, after 3 years, suddenly the cars start to fail. It's mysterious. Some of the unobtanium is corrupted. It's unpredictable. Some of the cars just stop, others keep going. Overall there's a 50% failure rate but no way to predict which ones will die and which will keep on going. Suddenly the resale market vanishes, no one wants the cars, and the stock price collapses overnight.

Why did the stop price drop so precipitously? The problem with unobtainium existed all along. But no one knew about it. One morning everything was fine, Woodside Cars was worth $50 billion, the next morning, it was worth $25. The details aren't important, the important thing is: the world collectively decided that the company wasn't worth as much as they thought. The wisdom of the market took care of the rest.

Now we might pity poor Grandma Joe who had her life savings tied up in Woodside stock. But only stupid people invest their net worth in the shares of a single company, right? Not so fast. Many people had their money in Woodside. Woodside has been making cars for 70 years and has always been stable before. Even charities, and small companies, have their money in Woodside shares. In fact, millions of people had their money in Woodside. Fortunately, they still have half their money left.

And then the lawsuits start. People are mad that their cars are broke. They start a class action suit. And it looks like that suit could drag down Woodside's remaining business in regular cars, even though those regular cars run on gasoline and electricity. This is bad news for Woodside shareholders. They run the risk of Woodside's "toxic business" dragging down its regular business and making their shares worth a big fat zero.

So the government steps in. "Woodside is too big to fail" say prominent business leaders and politicians. "Just think of the economic damage that it could do." First they loan Woodside money to buy back the bad cars, and then the split Woodside into two companies ‰ÛÒ one to carry on with the good business, and the other one to deal with the broken cars and the lawsuits.

Of course, in reality very few people would put all of their money in a company like Woodside. Woodside was free to develop and trade in new kinds of cars, based on any kind of fuel they like. Banks, on the other hand, have restrictions. They are regulated and insured and subject to constant scrutiny. Banks aren't companies... they're banks.

They used to be.

Now they are companies.

In fact there's even a phrase for it: the "shadow banking system". It sounds scary, and it should because it's regular companies, with all of their exposure and foibles, pretending to be banks. These so-called "financial services companies" are just as innovative and subject to unexpected losses as any high-tech, manufacturing, or services company, just as they wormed their way into the heart of the world's monetary system.

Too big to fail? Yes, Dorothy, they are too big to fail. Like Woodside, if they fail, suddenly a lot of individuals and businesses ‰ÛÒ perfect good citizens who truly believed that they were investing their money wisely ‰ÛÒ are going to be broke. And through no fault of their own. The effects will spread. People who never touched a Woodside car will suffer.

Yes, the executives should be axed. Yes, the regulations should be changed. But the company is really a bank, whether it's Woodside Cars, or AIG, and needs to be treated as such. If it's allowed to fail, then the economic costs will be massive. Certainly the company made mistakes, and there's good reason to punish it for that. But. They didn't break the law. Unobtainium was legal when it was introduced. Maybe it shouldn't have been, but it was.

Of course the real situation is much worse. It's like unobtainium has been added to the fuel of every car that anyone makes or drives, except that no-one knows which cars are good and which cars are bad. Unobtainium has become so essential that there's no way to quickly remove it from the transportation system ‰ÛÒ it will take years. Car companies are struggling to figure out which of their suppliers have tainted parts. Even the government can't figure out which parts are good and which are bad.

That's more like the actual banking crises. Unobtainium is bad debt. Oh, there's a million ways to name it ‰ÛÒ CDOs, MBSs, CDSs, etc., etc., but it's all fundamentally bad debt. These shadow banks, running amok, have infected the entire system. When no one knows which accounts are good and which are bad, they won't borrow and they won't lend.

The knee-jerk reaction is to save the system by destroying it. Let them fail. That is short sighted. All of our so-called money is inside these companies. If they fall, we fall. Yes, we must fix the system, punish anyone who broke the law, and  change the rules so this won't happen again. But that's a very big job and won't happen overnight. In the meantime, unobtainium has infected the system so badly that it needs heroic measures to stave off total collapse.

Next time I'll talk about why the fundamental rules of executive compensation created this problem, and how I think they must be changed to make sure this "never happens again".