osewalrus (osewalrus) wrote,

Because Recognizing Gutsy Decisions Is Important.

Ben Bernake and Hank Paulson will either go down in history as brilliant men who stepped up during a financial crisis and saved the economy or as reckless gamblers who blew the best chance to slow things down before they reached a crisis.

Both bucked conventional wisdom twice. In Bernacke's case, he stepped into the hole created by a decade of deregulation, stretched the authority of the Fed to cover a crisis situation, and bailed out Bear Sterns. In Paulson's case, he stood up to the Administration's "hands off" policies and supported the rescue of Fannie and Freddie. Then they had the courage to make the entirely different decision on Lehman Bros and AIG, sending a signal to the market that the Federal government would not (and, if one looks closely, could not) go on buying people out of the messes they made.

It takes guts to buck the conventional wisdom, and the more so to know when real differences in facts on the ground mandate different results. In this case, Bear Sterns was smaller and its collapse unexpected. Allowing it to fail risked a sell off and massive tightening of credit. Nor did the restructuring amount to a direct bail out. It was based on a theory that Bear Sterns' loses were manageable over time, if a buyer could be given sufficient guarantees to take on the job of restructuring.

In the case of Fannie and Freddie, we are talking a substantial portion of the retail housing market. Collapse of these two institutions would have made it nearly impossible for any buyer to get reasonable credit. Trade in commercial paper would have gone belly up overnight. Again, the looming specter of a modern collapse that would tank the economy for years prompted a need for drastic emergency action.

But Lehman and AIG are not in either category. The market has known for months that these institutions had real problems. While their collapse causes real pain, this is precisely the case where policy makers need to ask "do we need to take a hit now to avoid massive damage later or do we need to intervene to keep the economy from going comatose." This is also the sort of case that can lead to the "moral hazard" problem. It would not do to have every trader and hedge fund manager think that they need to engage in ever more risky and complex transactions for the express purpose of ensuring a federal bail out. Having established that the Federal government would act when necessary, it was also important to show that the federal government will let firms fail when necessary.

It's a risk. Because even with a weekend of due diligence and a market firmly warned that it needs to take its medicine, too many factors can still throw the economy into shock. If foreign capital dries up too quickly, or we see a run on the dollar because governments have lost faith in our economy, we may look on the failure to prop up Lehman as the first domino in a modern bank run. OTOH, the threat that saving Lehman, AIG, and some unknown number of other institutions would trigger the kind of long term stagnation that Japan suffered after its bank collapse could not be ignored -- even if it was the safer course in the short term.

I am also compelled to give a backhanded compliment to Bush. I'm glad it only took 7 years for him to learn wisdom and start placing competence over ideological purity and loyalty. It does not relieve him of responsibility for this mess, but I'm glad it's happening now.

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