The Economic Doomsday Device

In the movie Dr. Strangelove or: How I Learned to Stop Worrying and Love the Bomb, the Soviets take mutual assured destruction to the logical extreme by creating a device, that would destroy the world if a nuclear device was ever detonated. The producer of the movie, obviously wanted to parody the notion of mutually assured destruction, but there are applications of this principle that could be applied to our financial institutions.

The principle long term problem with this nation's economy is that large financial institutions (hereafter sloppily referred to as banks) are operating with an implicit subsidy from the federal government. They know that if they bet with the system, the federal government will simply bail them out. The government cannot credibly threaten to let too-big-too-fail banks fail. Whatever law that the Senate or Congress pass, absent an amendment, could be easily reversed in the case of political expedience. The reason for this, is that the banks have a first mover advantage in this game of Chicken.
Here is a matrix that describes the potential payouts for the market given a collapse

	Government let's banks fail	Government bails out banks
Banks take high risk	0,-5	5, -3
Banks take rational risk	1, -1	2 , -2

As you can tell, the banks would clearly prefer to be in the right half of the matrix. They have the first mover advantage in this game, since they can take high risk and essentially force the government's hand in a bailout. If the government could somehow take the first mover advantage from the banks, and credibly threaten to let banks fail, then they would not take systemic risks in the first place. As mentioned earlier, no legislation can credibly threaten to let the banks fail, as it could be overturned by a scared Congress.

That's where my economic doomsday device comes in. The United States Federal government should create a derivative that pays out a sum of gold to the buyer of this derivative if the US Federal government bails out a financial institution. One would of course have to go through the trouble of delineating what constitutes a bail out, but once you have that, you could then turn around and sell these derivatives that payout gold from the US gold reserve in the event of a bailout. If the US government were to sell enough of these strange financial instruments, to the point where a bailout would essentially lead to bankruptcy of the federal government, then the government will have credibly threatened to let the banks fail, and will have taken away the first mover advantage from the banks. It may also need to be administered by a third party which would posses the gold reserve for the duration of the contract in order to avoid the legislature simply changing the terms of the contract unilaterally. Below is the revised matrix, given the economic doomsday device.

	Government let's banks fail	Government bails out banks
Banks take high risk	0,-5	5, DEATH
Banks take rational risk	1, -1	2 , DEATH

As you can tell in the above matrix, by changing the payoffs government faces, banks realize that a bailout is impossible and take rational risk.

Yes, this is absolutely crazy. It is so crazy it just might work. 

Depute – to appoint, entrust
Desultory – loose, rambling