There has been buzz for the past several days that the federal government would move to bail out Fannie Mae and Freddie Mac, and now appears the rumors have proven correct. This follows not so long after the bailout of Bear Stearns. I don't know enough about the banking market to say whether the government has made the right moves with respect to these bailouts, but it strikes me as odd that any private entity should be considered "too big to fail". It seems there two potential routes around this: either ensure that no single firm in a given market obtains enough market share to make its collapse catastrophic, or simply put the critical functions under public control. The former option is problematic in that a) it would require a far more robust (and I mean FAR more) and aggressive type of antitrust regulation than we currently have, and b) it is easy to imagine that, even with a larger number of firms, intense competition might lead the firms to adopt similar approaches such that numerous firms would teeter on the edge of collapse at the same time, and a bailout would be required anyway. The latter option is problematic for the obvious reason that markets are generally more efficient than government management. But this system where private companies are free to reap really impressive profits (as the investment banks have), but the public ultimately bears the downside risk seems untenable.
This problem has always been at the foundation of my opposition to any sort of privatization of social security. In fact, it's worse for social security than for the banking system, because with social security you've got two levels risk to deal with--the institutional and individual. Because even if whatever private institutions we hand the system over to don't fail, if a significant number of individuals managed their risk poorly and get cleaned out, I find it inconceivable that the government wouldn't step in to rescue them. That is, after all, the entire point of the program. It's social security. And once that happens, of course we'd expect everyone else to try to shoot the moon with their investments, because what's the downside? This is the sort of risk we don't want to be distributed. It only works when the risk is pooled. Look for similar problems with some sort of hybridized public/private health insurance. Once we've made a social decision that some service is necessary, for whatever reason (economic stability, national security, moral obligation), handing it over to private entities will necessarily create serious problems with risk management and moral hazard.
I'm not necessarily arguing that, for example, our entire banking system or health care system should be government run. But I do think that in terms of structuring the mix of government and private management of such critical functions we need to try to identify key breaking points and either put them under direct government control or develop some clever system to ensure that private entities approach these functions with the right set of incentives.
Update (7/14): Sebastian Mallaby appears to have a similar take on the issue to mine.