ONE cannot speak about bailouts without addressing moral hazard concerns. Tyler Cowen writes:

[E]ven if nationalization is the right response this time, it might not be the next time a financial institution gets into fiscal trouble. Yet in that subsequent case nationalization will be that much harder to avoid, given the understandable fears of private capital if nationalization happens this time. Every time you nationalize and wipe out shareholders, you create a dangerous precedent and scare away private capital for a long time. You are probably reading lots of absolutist recommendations around the blogosphere but these are truly difficult issues and the correct policy responses are not obvious.

This is the heart of the moral hazard argument—if you do it this time, markets will assume you'll do it next time and take on excessive risk accordingly. The response of those in favour of a bailout is two-fold. First, because these GSEs are odd organisations, other firms shouldn't assume that the same rules would apply to them (although the Bear Stearns fiasco suggests they might). Second, regulations are sure to change significantly after all this is over, suggesting that next time won't look anything like this time.

The Federal Reserve and its partners in financial firefighting have added another bulwark against moral hazard—ensuring that firm bailouts punish shareholders as much as possible. But this strategy comes with its own hazards. Ricardo Caballero elaborates:

By punishing equity holders, the Treasury chose to hurt those that it had invited to stabilize the situation just a few hours earlier. In doing so, it may have damaged its ability to leverage its policies with private capital support, a key aspect of policy success in dealing with a coordination failure problem. Second, during periods of high uncertainty and the potential for runs, large or coordinated shortsellers are more likely to succeed in triggering socially inefficient panic-selling. Rumor-mongering and persistent selling pressure eventually weaken wary investors and depositors. Unfortunately, by choosing to punish shareholders, Secretary Paulson has rewarded shortsellers and raised their ammunition to cause further financial instability. Again, while shortselling plays a very useful role during normal times, it can turn into a source of instability during periods of high uncertainty.

This is an interesting argument. While the government's punish-the-shareholders plan should encourage shareholder prudence, it might also mean that the mere whiff of crisis sends equity holders to the exits, thereby producing actual crisis. Not exactly what Mssrs Bernanke and Paulson are after.

But is shareholder flight all that bad? Felix Salmon isn't so sure:

Clearly, we're in a world where the biggest risks to the economy remain financial. And it just so happens that there's an easy and reasonably effective way of hedging those risks: shorting financial stocks. Investors around the world who want to protect themselves against market-crisis risk are likely doing just that right now, helping to drive the price of those stocks downwards. Which means that as the stocks of big banks fall, quite a few sensible investors are actually making money. Not because they're betting on Armageddon, but just because they understand the big risks and are hedging them accordingly. Indeed, broad stock indices have been remarkably calm over the past few sessions, in the face of all the financial-sector craziness. The share-price volatility in Fannie and Freddie over the past few sessions looks to me as though a hell of a lot of people are playing in those stocks, and that most of them are not buy-and-hold investors from years ago who are now finding themselves underwater. Indeed, I'm almost reassured by all this stock-price volatility. Equity, sitting as it does at the top of the capital structure, is never going to be a safe place to be during a crisis. But it just might be the case that the crazier the rollercoaster ride suffered by shareholders in Freddie Mac, the safer the rest of us can feel, if that rollercoaster ride is partly a consequence of prudent risk management elsewhere in the system.

In other words, the problem might not be panic selling, but rather an appropriate assessment of market risk. On the other hand, the problem might be panic selling.

The real sticky issue seems to be that the Federal Reserve and the Treasury are often pulling in two different directions at once—attempting to prevent bank failures with one action while sending the message that shareholders in failing banks should get what they can when they can with other policies. It's interesting—most discussions of the moral hazard implications of Fed actions have focused on how those actions might determine behaviour in the next crisis. In the end, concern might have been better focused on the implications for behaviour in subsequent months of the current crisis, which is still going strong one year on.