In an interview, Ricardo Caballero says,

it’s ludicrous to suggest that anticipation of support (a “bailout”) in an extreme systemic event is one of the most significant sources of moral hazard.

Pointer from Mark Thoma. Caballero represents one end of a spectrum of thinking on financial regulation. That end, which includes Gary Gorton and Perry Mehrling, does not believe that government backstops create inevitable moral hazard. Instead, they argue that with proper regulation, government backstops can permit the financial system to satisfy people’s desire for safe assets.

The opposite view is the one held by Nassim Taleb, Russ Roberts, Jeffrey Friedman, and myself. In our view, markets will find a way to load risk on to any government guarantor. Eventually, regulatory controls get gamed. The regulatory mechanism steers financial firms toward a common risk factor. When failure comes, it is catastrophic.

[UPDATE: Friedman emails me to say that he agrees with Caballero in that he does not think that bankers intentionally put their institutions at risk in order to take advantage of bailouts. Well, sure, nobody wants to fail. But sooner or later you choose the lowest cost financing. And when your debt is insured, debt finance is cheaper than equity finance, so you maximize leverage. And when regulators tell you that your leverage can be higher if you hold AAA-rated securities, you get AAA-rated securities without asking questions about how robust they really are. So the moral hazard may not seem blatant, but it is there in the background.]

I have been saying for quite some time that the goal of government should be to aim for a financial system that is easier to fix rather than one that is harder to break. I also believe that a large financial sector that provides a lot of “safe” assets (safe only because of a government guarantee) is not obviously better than a financial sector that is only as large as it can be using the tools of diversification and skill at managing risk. Sure, we all want to hold lots of safe assets and to issue risky liabilities, and the larger the financial sector, the more we can do that. The financial sector does the reverse.

But ultimately, the financial sector (including government) is not some separate entity. We as investors and taxpayers ultimately have the financial sector on our balance sheets. By creating the illusion that there are more safe assets in the economy than actually exist, we end up fooling ourselves.

I have a lot of respect for Caballero, Gorton, Mehrling, and some of the others who share their view. Still, as you can tell, there is a sharp divide on this issue.