It's The End of the World As We Know It ...

and I feel fine.

This from Willem Buiter - professor of European political economy, London School of Economics and Political Science:

"This is what I read this morning, 17 September 2008, on FT.com: "The US Federal Reserve announced that it will lend AIG up to $85bn in emergency funds in return for a government stake of 79.9 per cent and effective control of the company - an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system. Under the plan, the existing management of the company will be replaced and new executives will be appointed. It also gives the US government veto power over major decisions at the company" (see "US to take control of AIG", Financial Times, 17 September 2008)

I almost decided to go back to bed, convinced I must be dreaming.

The proximate cause of the demise of AIG as a private firm was its "monoline" activities, its exposure to massive amounts of credit-risk derivatives such as credit default swaps (CDS), many of them linked to the United States real-estate sector.

The largest insurance supermarket in the world, with a balance-sheet in excess of $1 trillion nationalised because it was deemed too big and too globally interconnected to fail! The fear that drove this extraordinary decision is that AIG's failure would increase counterparty risk - actual and perceived, throughout the financial system of the US and the rest of the world alike - to such an extent that no financial institution would have been willing to extend credit to any other financial institution. Credit to households and non-financial enterprises would have been the next domino to fall - and, voilà!, financial Armageddon.

I cannot judge the likelihood of the disaster scenario, but if there ever was a case for applying the precautionary principle in economic analysis, then this is it. It was also done in the right way, by insisting on controlling public ownership, i.e. nationalisation, of the company.

The existing management is gone - again as it should. We will find out whether they left with golden parachutes or with just a cardboard box packed with their personal belongings. The precise implication of the deal for the old shareholders will also matter for the ultimate judgment on its fairness and on what it does to incentives for future risk-taking. Since the existing shareholders were obviously not completely wiped out by the deal, they do well out of it - probably too well. The public takeover appears to imply that all creditors other than the ordinary and preferred shareholders will be made whole. From the perspective of incentives for future excessive risk-taking, this is regrettable. A charge on the creditors, modulated according to the seniority of the debt, would have been preferable.

But perhaps my concern about incentives for future risk-taking is moot, because it assumes that private, profit-seeking enterprises will again, in the future, pursue the kind of financial activities engaged in by AIG. If financial behemoths like AIG are too large and/or too interconnected to fail but not too smart to get themselves into situations where they need to be bailed out, then what is the case for letting private firms engage in such kinds of activities in the first place? Is the reality of the modern, transactions-oriented model of financial capitalism indeed that large private firms make enormous private profits when the going is good and get bailed out and taken into temporary public ownership when the going gets bad, with the taxpayer taking the risk and the losses? If so, then why not keep these activities in permanent public ownership?"

Read the full article here.