[Pen-l] Why AIG Must Be Bailed Out

[Michael Perelman <michael@xxxxxxxxxxxxxxxxx>]

Suppose somebody wants to make a bet with me that the San Francisco 49ers will win 
the next two Super Bowls.  He gives me $100 today, and I have to give him $100 
million in case he's right. The chances of this happening are very small, but just 
in case the impossible happens I want some backup. I buy insurance from my next-door 
neighbor.  I offer to give him a nickel every week in return for his promise to 
cover my bet.

My neighbor sees that he has a good thing going -- getting money for nothing.  After 
a while he takes on more and more bets until others follow in his footsteps.  Soon, 
a market develops.  In effect, people can bet on bets. Eventually, the total 
potential amount of money builds up into the billions and trillions of dollars.

Unexpectedly, the San Francisco 49ers win two Super Bowls in a row.  My neighbor 
does not have $100 million on hand to cover my loss.  The nickels I have been giving 
him have been wasted. I don't have $100 million either.

Suddenly everybody in the market is worried about people's ability to back up their 
bets. The Federal Reserve steps in and takes over the market.  The free world is 
saved.
 -- 
Michael Perelman Economics Department California State University Chico, CA 95929

Tel. 530-898-5321
E-Mail michael at ecst.csuchico.edu
michaelperelman.wordpress.com
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