One of the Fed's primary responsibilities is to act a "a lender of last resort." This is due to the fact that bank runs and bank panics can lead to financial market instability. When financial markets falter, there is less investment in the economy. This leads to less aggregate demand, which can increase unemployment. It also can reduce future economic growth.

In the 1930s the Fed, during the height of the Great Depression, decided not to act as a lender of last resort. There were many bank runs, and this hurt the economy, prolonging the Depression. The Fed justified this by appealing to an idea called "moral hazard." Essentially, the moral hazard argument says that if someone is insured against the adverse outcomes of an action, they are more likely to carry out that action. For example, if you have fire insurance on your home, you may be less likely to install equipment that protects your house from fires.

In financial markets, the idea of moral hazard is that if the Fed "bails out" banks that make bad loans and bad business decisions, then this just encourages banks to take on risky behavior. The Fed did not want to encourage this in the 1930s, so it let the banks fail.

In the 2008 recession, moral hazard reared its ugly head again. During the early 2000s, a run-up in housing prices led to an overheated housing market. Seeking to get rich by making housing loans, banks and mortgage lenders made risky housing loans that caused BIG BIG problems in the financial markets (lots of loans to people who bought houses they could not afford). When the mortgages went bad and people stopped repaying them, Wall Street crashed. The Fed and the governmentworried that these banks were "too big to fail"

"--bailed out the Wall Street banks at great expense to taxpayers and homeowners. People were very angry, The Fed and the government said they had no choice. The concern was "contagion" or "systemic risk."This is the idea that banks and other financial market entities are highly integrated with each other, and if one fails, it will take many others with it. The concern is that a collapsing financial market will freeze up credit markets and there will be no investment.

What do you think? Should large banks be allowed to fail? Why or why not?