American corporate capitalism is undergoing a test this year, and it's ironic that the nation that perpetually rails against "big government" is now grappling with the issue of big business -- in other words, businesses that are "too big too fail."

Some economists have detected a flaw in the American capitalist system (it's not the first nor the only one): namely, that if you grow you're business big enough, to the point that failure would create systemic risk, you may be reducing your career risk or opportunity risk as an executive. A truly big business may also create a condition -- others call it distorted incentives -- that encourage you to run the riskiest business model possible. The incentives encourage executives to go for the largest gain (or largest personal gain), because the downside is minor. If the risky model succeeds, you hit the jackpot! If the business edges toward failure, no worry: the federal government will come in and save you, to prevent unacceptable damage to the U.S. economy or the financial system.

A lot of public ownership lately

The U.S. government has intervened to stabilize or save AIG (AIG), Citigroup (C), Bank of America (BAC), Fannie Mae (FNM), Freddie Mac (FRE), Chrysler, and now General Motors (GM).

The Keynesian economic view, which includes many economic liberals, argues that the interventions were prudent and necessary: they decidedly represented the lesser of two evils, and that the business failures were unavoidable -- largely driven by circumstances beyond executives' control.

The cynical and jaded view argues that each was preventable: that somewhere along the line, decision makers at the top were gaming the system.

Libertarians would say, game the system all you want, just don't ask me, the taxpayer, to bail you out, if you fail. The libertarian critique, once again, represents an ideal that's not likely to be attained: imagine a world in which GM or AIG or even Citigroup are allowed to fail, and nothing really bad happens.

The conservative economic view argues that regardless of whether the business failures were self-willed or driven by circumstances beyond their control, if the model is unprofitable and the market says it will fail, then it should be allowed to fail, regardless of economic or social consequences.

Further, the conservative view would hold that if sheer business size alone guaranteed that the federal government would intervene in the event things went awry, then those businesses should not have been allowed to become that big in the first place. Conservatives shudder to think: imagine a system where the government routinely bails out failing businesses? Well, that's the system the United States currently has.

But the idea of not letting businesses get too big obviously conflicts with the other core conservative economic tenet of private decision making for commercial operations, and that's where the crux of the debate will lie. Which is supreme? Private determination regarding just how large a business should be? Or a government-imposed restriction on business size in order to limit taxpayer bailout exposure?

Which ever path the United States chooses -- rightsizing a corporation to reduce the taxpayers' risk or the elimination of the 'too big too fail' fallback -- American capitalism will change, because it has to. Right now, there's just too much upside and not a whole lot of downside for 'institutions deemed critical' to the U.S. economy.

And that's not a circumstance you want when you're the one footing the bill.

Financial Editor Joseph Lazzaro is based in New York.


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