Prosperity and legitimacy

There are, in general, three three things a government needs to create and sustain legitimacy:

(1) National Identity: The government embodies the ideals and interests of a self-defining "people" (cultural/racial/ethnic/religious/etc) .

(2) Law and Order: The government has the monopoly on overwhelming violence, and no one is inclined to challenge it.

(3) Prosperity: Life is better with the government than without it.

The US is pretty comfortable with (1) and (2). The ongoing debate about what it means to be "American" will likely, hopefully, never end. Our political leaders are drawn not from any particular demographic; waves of immigrants have contributed. Our inclusive political and commercial process is more appealing than trying to seize power outside of them. Our military and law enforcement systems are not perfect, but it's tough to find better.

However, the third leg of the stool is the tricky one. Prosperity is a highly subjective thing, but in general the greater the ability of a society to allow individuals to consume resources, the more prosperous it is. This is why, in a society that simply has too much debt, the stated policy goal is to "restore lending." To do otherwise is to admit that we've run out of future to raid, and our government has failed to provide the prosperity we expect. As always, it is the new middle class that reacts most strongly to losing its run on the ladder, but try to imagine an American city losing reliable internet, phone, electricity and water services.

So, why bail out AIG? Because, if you go back to my little story of Bob's Investment House, the reason WSB was willing to give BIH that big loan was the insurance policy AIG was willing to write against BIH defaulting. The "guaranteed 5%" investment BIH found was backed up by a second AIG insurance policy. So, if anyone seriously believed that AIG would collapse, WSB would "call" its loan to BIH (much like when you pull money out of a savings account), BIH's clients would demand their money back, and the value of all the mortgages in the MBS would collapse as Bob and his staff tried to arrange a firesale while everyone else was doing the same thing. The knock on effect is that an unpleasant deleveraging spiral like we're seeing now would turn into a pretty massive calamity as the banks that hold the cash for large corporations fail, leaving even well-heeled companies unable to pay their workers. City services would fail as those workers weren't able to pay their taxes, and huge swathes of the country soon start to resemble third world countries with inadequate power and sanitation.

The problem is not the bailouts and certainly not the bonuses. From policy makers to investors to voters, we all made mistakes, and now we're trying to clean up the mess. The bigger issue here is whether or not we want a world in which "prosperity" means committing as many people as possible to give as much of their future income as possible to securities owners (like hedge and pension funds) and financial services companies. Some good things to get upset about are that our entire system is based on unsustainable borrowing against future income, that we need unsustainable resource harvesting and consumption, and that the path to "prosperity" offered today was a path to slavery in the past.