...may well go down as one of the most important events in the history of American capitalism. Gross hyperbole? Maybe. But I choose my words carefully. In Bloomberg this morning, Fed governor Janet Yellen is quoted as saying that it was a mistake to allow Lehman to collapse, that the firm was “too big to fail,” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.The article goes on to say that:
Some experts have since said that the U. S. gazed into the abyss after the events of September 15. I don't know. It's above my pay grade. (Actually I don't feel so bad about that. From the look of Bush during the crisis, he didn't understand it, either. And he was the president! Neither did McCain or Obama, for that matter.) But to me this is the question upon which this entire financial crisis hinges. Were these firms, Fannie, Freddie, AIG, Citi, etc. too big to fail? Were they so large and their counter-party obligations so vast as to endanger the entire U. S. economy and by extension, the world's? Would ATMs have ceased working? Would companies have been unable to meet their payrolls? Would things have descended into chaos? If so, then we did the right thing. But I don't know. Again, it's above my pay grade. Sounds a lot like the Y2K fears that never came to pass. Or the "mushroom cloud" scare tactics that the Bush administration used to rush us into the Iraq War. But when the chairman of the Fed, Ben Bernanke, who is considered to be an expert on depressions, and the former CEO of Goldman, the Cadillac of Wall Street, Hank Paulson, tell me that we need hundreds of billions to bail out these firms or else the doomsday scenario will play out, who the hell am I to argue? And what's more, who the hell are the Republicans--including Dick Armey and Newt Gingrich--to argue? So we bailed them out and Armageddon was averted. For now.
Since then I've read that Paulson bailed out AIG to save Goldman. Perhaps. But that sounds like a conspiracy theory to me and I'm naturally skeptical of those. And besides, how does that account for Bernanke's role? He sure seems impartial to me. No, as far as I'm concerned if two of the top experts in American finance tell me something, I have to take their advice. It's just as if the best neurosurgeon in town tells me that I need to go under the knife or else I'll die. I'm just not going to argue. He's got the fancy degrees hanging on his wall; I don't. And it's my life we're talking about here.
So back to Lehman. How does that decision become the most important in the history of American capitalism? Because it justifies the government's role in the economy. If Bernanke and Paulson were right and these institutions were too big to fail, then Armey, Gingrich, Rick Santelli, Ayn Rand devotees, followers of Milton Friedman and all the Austrian economists like Hayek and von Mises, libertarians, all the congressional Republicans that voted against the bailouts and the stimulus and all the teabaggers that protested on Wednesday are wrong and need to shut up once and for all. If the economy and the financial system have become too complex and interconnected, then large firms like AIG and Lehman cannot be allowed to fail. Maybe firms that are too big to fail should not be allowed to become too big to fail. But that requires government intervention also. Either way, the government has a legitimate role to play in the economy and the free-marketeers are discredited. If companies like AIG and Lehman can fail with no systemic risk to the nation, then the pure capitalists are right and the free market should resume its job of picking winners and losers.
But my sense is that the world has just gotten too complicated for the free market approach. This isn't the nineteenth century and we're not going to eliminate the Fed or go back to the gold standard. And derivatives and complex financial transactions are not going away. It's just not going to happen. We've come too far down the road of government intervention in the economy to turn back now. We can debate its merits all day long but it's kind of like debating the merits of the automobile over the horse and buggy--at this point it's academic.
The problem with economics is that unlike the hard sciences we can't go back in a lab and test what would have happened. Maybe if AIG had failed we would have all survived just fine, thank you, and saved billions (no, trillions when you add it all up). But we don't have that luxury. We'll never know what would have happened. So either Bernanke, Paulson, Geithner, and Summers are right and the economy recovers or it doesn't and the Armey-Gingrich crowd takes over in 2012. And if they do and large financial firms are allowed to fail with no dire consequences for the economy, then they were right and all of this money we spent was a colossal mistake. But if it's determined that some firms can't fail, then the government has a legitimate role in the economy and the argument is settled.
Another analogy is the U. S. role in World War II. Before the war, Charles Lindbergh and the America First crowd argued against American entry into the war. Had the war gone poorly, they would have been vindicated and it could have changed the course of U. S. foreign policy. But the war went well, and the isolationists were never heard from again. They may or may not have been right, but the victors (in this case the interventionists) wrote the history.
So stay tuned, and see how this one plays out. It just might be the most pivotal event in modern American economic history. It could set the tone for the role of government in the economy for years to come.
2 comments:
Whats this free market idealism? There isn't any question that the government has a role in the economy. Its the overall safety net for capitalism. The FDIC, SEC, Federal Reserve wouldn't exist in a truly free market economy. The US has learned the hard way that free markets overheat from time to time as a result of excessive leverage. In times such as these the government's role is to restore confidence in the financial system and provide the necessary liquidity to keep the economy functioning.
The events of last September and the resulting collapse in the capital markets is a direct result of the failed leadership of George Bush and Henry Paulson. The two worst decisions made last fall involved the takeover of Fannie/Freddie and letting Lehman go under. Both of these events have to be tied to the poor judgment of Paulson since Bush was basically disengaged from any leadership responsibilities during the crisis. Contrast Bush's lack of involvement with Obama's approach since he took office.The difference in quality of leadership is obvious.
Paulson's decision to invest in Fannie at a level in the capital structure that was above recently issued preferred stock was a mistake. He basically flushed all of the common and preferred sharhoders as a result. This was the decision of someone that was making a for profit investment rather than a government safety net type investmnet. When the preferred at Fannie became worthless it basically closed the equity markets for fresh capital for finaincal institutions to replace losses and remain solvent. This contributed to the demise of Lehman, Washington Mutual, AIG etc. as the capital markets closed because investors did not want to to be wiped out by the government as they were in Fannie. So this left the US as the only source of capital for these organizations.This dramatically increased the stock markets lack of confidence in these institutions. As Lehman wavered Paulson decided he needed to preserve the ideal of a moral hazard. The market was expecting the US to function as a safety net similar to how it approached Bear Stearns and others. Surprise! Lehman filed for bankrutcy and once again shareholders, both common and preferred, were wiped out with bondholders getting 10 cents on the dollar. Money market funds broke the buck becasue they owned Lehman commercial paper that was marked down substantially. Every institution in the world was impacted. It destroyed confidence at every level of the market. And yes the markets stared into the abyss and blinked. The government was forced to come to the rescue of the commercial paper and money markets with its guarantee of all issuers. Without this guarantee liquidity in corporate America (including payrolls etc.) would have been disrupted. Bernanke said the reason they didn't put money into Lehman was that there wasn't aceptable collateral.Thats BS. Times like that require bold decisions. The government needs to put their capital at risk at a level junior to or at least no more than equal to other investors. Thats what creates the safety net!
The fall out from this crisis and the government's poor reponse will set back the capital markets and the economy for years and years.Growth will be anemic going forward. The shadow banking system has been largely dismantled. Mortgages, car loans, student loans etc. will be more difficult to obtain without the securitzation market.The markets are still not operating independently. Company's like American Express can not sell commercial paper at reasonable rates without the government guarantee. I think we will see large mergers creating a handful of too big to fail institutions when this is all said and done.
Somehow I think we would have survived this crisis and returned to a more dynamic economy if Paulson had not destroyed the confidence of investors. It will be interesting to see how Paulson and Bush are evaluated by historians. In a way they let the genie out of the bottle and the consequence will be that capital markets won't function as well for years to come.
Thanks for your comment. You don't absolve Bernanke of responsibility, either, I notice.
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