The average citizen may feel confused.
In March, we heard it was essential the Federal Reserve lay out an unprecedented sum of money to keep Bear Stearns from collapsing. In July, Treasury Secretary Henry Paulson told Congress it was essential to the U.S. economy that Fannie Mae and Freddie Mac not go belly up, but that giving him a ‘bazooka’ of loan guarantee powers might mean that he would never have to use it.
By September, the bazooka clearly was a popgun. To keep a failure by Fannie and Freddie from harming other financial firms and to maintain some supply of new mortgage money, we were told the government had to take another unprecedented step by essentially nationalizing these two publicly traded enterprises.
Yet one week later, Paulson said, “I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers,” and the investment bank went into bankruptcy Monday.
The day after Lehman turned turtle, the Fed made an unprecedented $85 billion bridge loan to AIG, the world’s largest insurance firm, once again arguing that allowing a big firm to fail would cause financial havoc.
If you got mental whiplash in trying to follow all this, you are not alone. How are we supposed to understand when something is really too big to fail?
While many economists acknowledge that the failure of a very large financial institution might trigger market chaos and a severe recession, there is no real way of identifying when that is true and when it is not. As a result, Treasury and Fed officials improvise on a day-to-day basis, making snap judgments as events unfold.
They are a bit like the people who sex baby chicks to get laying hens. The sexer grabs a chick, takes a quick glance and tosses it to one side or the other. Perhaps a fifth of a second suffices to scan a few external characteristics and decide whether the chick should be saved for a life in a wire cage laying eggs or be killed immediately. Even an experienced sexer sometimes makes mistakes. To an onlooker, the process and the sorting criteria don’t make any sense at all.
Trust us, our leaders say. A bankrupt Bear Stearns would hurt society more than the some $30 billion in what is effectively public money the Fed lent to help Bear find a buyer. And maybe we’ll get the money back. Ditto for Fannie and Freddie, on a much larger scale.
But no, Lehman, on the other hand, doesn’t deserve help. It had many chances to get help in the marketplace and it spurned them. Besides, other firms it owes money to have had months to make defensive moves. But AIG is different; it is too big.
In the short run, there isn’t much to do besides hope Treasury and Fed officials are making the right calls.
In the longer run, there are some things our society can do to reduce the likelihood of similar debacles in the future.
First, recognize that critics of the “too big to fail” doctrine, like Minneapolis Fed President Gary Stern and his associates Art Rolnick and Ron Feldman, were right in their warnings more than a decade ago. The tacit assumption, both by government and financiers, that some institutions are too big to fail and necessarily will be bailed out creates incentives for big institutions to take risks that inevitably will put some in situations where they are broke and need a bailout. Too big to fail becomes a self-fulfilling prophecy.
Recognize also that there have been at least three times in U.S. history when the collapse of a large commercial bank or other financial institution touched off widespread problems. In 1893 and 1907, there was no central bank to respond. In 1929, the Fed flunked its first test.
And in Europe in 1931, the collapse of an Austrian bank, Credit-Anstalt, contributed to economic problems that facilitated Adolf Hitler’s rise to power and the onset of World War II. So the risk is not entirely mythical.
Is there a way to avoid getting to such a point? First, prudent regulation by the Fed and Securities and Exchange Commission can reduce risk-taking and overleveraging. But the task isn’t as simple as it sounds and it can create a false sense of security.
Second, government should not deliberately foster the growth of large institutions. Fannie and Freddie did not achieve their mammoth size through superior management or as the result of market forces. Successive Congresses and presidents created the problem.
Third, let enough firms fail that the rest at least worry they might not be rescued. It is like the French army in 1917 massacring a few mutinous battalions “to encourage the rest.”
This seems to have been a key reason Lehman was allowed to die. Unfortunately, the immediate succor extended to AIG, however necessary to authorities in the know, blunted the incentive effects of Lehman’s death throes.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.