What am I so afraid of?

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Tyler Cowen lays it out:

The best case scenario: The bad banks continue to be bought up, there is no run on hedge funds next Tuesday, only mid-sized European banks fail, money market funds keep on buying commercial paper, and the Fed and Treasury continue to operate on a case-by-case basis.  Since Congress doesn't have to vote for something called "a bailout," it can give Paulson and Bernanke more operational freedom than they would have otherwise had.  The American economy is in recession for two years and unemployment does not rise above eight or nine percent.

The worst case scenario: Credit markets freeze up within the next week and many businesses cannot meet their payrolls.  Margin calls cannot be met and the NYSE shuts down for a week.  Hardly anyone can get a mortgage so most home prices end up undefined rather than low.  There is an emergency de facto nationalization of banks to keep the payments system moving.  The Paulson plan is seen as a lost paradise.  There is no one to buy up the busted hedge funds, so government and the taxpayer end up holding the bag.  The quasi-nationalized banks are asked to serve political ends and it proves hard to recapitalize them in private hands.  In the very worst case scenario, the Chinese bubble bursts too.

Tyler notes "I still think some version of the best case scenario is more plausible, but I wish I could tell you I am sure."

I'm not sure I have a good p-value on the worst case scenario.  More importantly, I'm not sure how to weight risks with small probabilities but catastrophic consequences--an issue we've been struggling with in assessing climate change action, among other economic policy questions of the day.  If there's a 5% chance of the above scenario, how much should we be willing to pay to avoid that risk?

It is worth noting, in answer to the libertarians who are wary of government intervention in the economy, that if there is a serious crash, we will get even more government intervention in the economy--and intervention that is much less to our liking.  That cost has to be weighed in your assessment.  On the other side, to those who are averse to bailing out Wall Street rather than Main Street, it's worth noting that Main Street will suffer worse than Wall Street.  Because of the way that their compensation is structured, Wall Street bankers tend to do things like buy their houses for cash.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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