Free market advocates are sometimes viewed as unrealistic ideologues, obsessed with issues such as moral hazard at a time when there is a need to stabilize financial markets.  In fact, it is the seemingly pragmatic interventionists that are being simplistic, as they overlook the long run impact of their actions.  Each bailout encourages even greater risk taking, making the financial system even more unstable.

In some cases, the advocacy of intervention is based on a misreading of history.  The financial instability experienced in the US prior to 1933 was not caused by laissez-faire, it was caused by a combination of bank branching prohibitions and unstable monetary policy.  And even then, the larger banks survived declines in NGDP that would wipe out the entire modern global banking system.  Canada’s system was much less regulated than in America, and had relatively few problems during the Great Depression.  Financiers behaved more responsibly back before FDIC.

Bloomberg has a good piece explaining how the Bank of England is creating ever more moral hazard, extending bailouts beyond just the banking system:

So when the gilt market wobbled last week, there was no one left other than the Bank of England with the firepower to intervene.

Fortunately, the BOE had already laid the groundwork. In January 2021, its executive director for markets, Andrew Hauser, made a speech in London outlining a case for its role as “market maker of last resort.” Central banks had already broadened their focus from backstopping banks to backstopping markets. But given the shifting sands under the overall system, he warned that the pace may increase: “There is every reason to believe that, absent further action, we will see more frequent periods of dysfunction in the very markets increasingly relied on by households and firms.”

And this problem goes well beyond the financial system.  Unfortunately, governments are increasingly determined to protect people from their folly, whether it be borrowing lots of money to earn useless college degrees or building homes in the path of hurricanes.  These protections cause people to behave still more foolishly.  Then we’ll be told of the need for even more regulation, to protect us from the even more foolish behavior.  Perhaps I should use scare quotes for “foolish”.  Given the government protections, much of the behavior is privately beneficial while being socially wealth destroying.

At a deeper level, this is all a part of what F.A. Hayek called the fatal conceit, the view that governments can control the economy.  Instead, government should focus on avoiding actions that destabilize the economy.  Hayek believed that the best way for governments to avoid destabilizing the economy is through NGDP targeting.  When NGDP is stabilized, we no longer need to fear that the failure of a large financial institution (or a major decline in asset prices) will lead to high unemployment.  NGDP targeting makes laissez-faire policies much more appealing.

PS.  Some people are wrongly suggesting that the Diamond-Dybvig model of bank runs provides justification for government deposit insurance.  George Selgin does an outstanding job (here and here) of explaining why that is not the case.