I’ve recently exchanged e-mails with Mike Barnett, a friend and colleague from the University of South Florida, who has not taken too kindly to the socialization of losses as a result of the credit crunch. Issues of social welfare are not my forte, but it is right up Mike’s alley – as one of the foremost young scholars in the field of corporate social responsibility. So I decided to give him a forum to express his ideas as a guest blogger. Hope you enjoy his perspective. I’m hoping he will chime in from time to time with his thoughts.

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I hate losing money – can’t stand it. On the other hand, I love gaining money – nothing better than a major windfall. Problem is, you typically have to risk losing money in order to get the opportunity to gain money; be it a trip to Vegas, a wild ride on the stock market, or the financing of a new firm. Most people, like me, are risk averse. Our hatred of losing money outweighs the joy we get from winning money by enough that we seldom take big risks, and so we don’t usually lose big, but we also don’t usually win big. However, we respect the risk takers, and we don’t begrudge their windfalls, because we know that the winners had the courage to bear the risk of losing big, and so they deserve the rewards of bearing that risk.

Now let’s modify that a bit; more accurate is that I hate losing my money. I’d be glad to lose someone else’s money all day long. And I especially love gaining huge sums of money for myself while risking losing someone else’s money. Imagine if a casino offered you the opportunity to gamble without the risk of loss; all losses would be forgiven, but all gains would be yours to keep. If you’re playing with house money, why not bet the house? It’s only rational.

We should expect exactly this type of behavior – moral hazard – when the government bails out failed risk-takers. In recent decades, the government has pulled back the taxes on large gains, giving the risk taker more and more of his reward; and so we get more risk-taking. That’s typically good for an economy in the near term (though it can harm tax bases & middle classes over time, and so be bad in the long term; a whole other issue). But the government has not pulled away the safety net, and so the risk-reward ratio has become asymmetrical – the rewards are high and the risks are low. If you fail, the government (through the taxpayer) bails you out. So why not take a lot of risks?

Consider what’s going on with the mortgage meltdown. The banking industry made huge profits off of writing risky loans, often in very creative fashion. But now that defaults are on the rise, and profits have turned to losses, bankers seek to shift the losses to the government. For example, Credit Suisse is pressing HUD to have the FHA guarantee mortgage refinancings (see Worried Bankers Seek to Shift Risk to Uncle Sam). Should we, the taxpayers, guarantee a bad mortgage that Credit Suisse probably should not have made in the first place? And sadly, Credit Suisse is not the only culprit. Other examples of shifting losses to the government abound.

We can admire the tight rope walker who spans the skyscrapers. He deserves the attention; he’s crazy enough to take this risk. But if we come to find out that it was a camera trick, and left outside of the frame was the fact that he was only three feet in the air, with a cushioned mat below him, then we lose respect. And this is how we lose respect for the free market system, too. If gains are privatized but losses continually socialized, we run the risk of disenfranchising many in society who will come to perceive the system as “rigged”. Socializing losses can be likened to a form of corruption, and in the long-term this is risky to the stability of our society.

Ultimately, we can’t justify huge winners unless they’re risking huge losses. So when we find out that they got their huge gains in prior years without walking a tightrope, we do begrudge their gains, and we don’t feel sympathy for their losses. And now they want us to absorb those losses??

We all love a free market, so long as we get to control it. The folks making obscene gains in some years gain the power to pervert the regulatory system and build a personal safety net for lean years. And, as taxpayers, we share less and less in their gains and bear more and more of their losses – the losses are increasingly socialized while the gains are increasingly privatized. Yip, it’s as corrupt a system as it sounds – Robin Hood in reverse.

There are two ways to go – go with a true free market and let folks fail, not just win; or put in a safety net via regulation that does not provide incentives for market participants to take reckless risk in the first place. Like I said, I’m risk averse, and so I don’t like the volatility of the former. Going for the latter would remove the asymmetry at the root of today’s turbulent market and create sound rules for a “fairer” game. So let’s not pull the net; let’s just lower the roof and use the excess material to build a stronger net. In Senate testimony today (Feb. 14), Bernanke reaffirmed the role of the Fed in providing “adequate insurance against downside risks.” It’s a question of who pays the premiums, who provides the reinsurance, and who acts as the ultimate backstop that determines the fairness of the system.

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