Dollars and Jens
Saturday, December 27, 2008
moral hazard
Tyler Cowen suggest that the LTCM rescue sowed seeds for the recent financial crisis:
At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system.
I've argued before that regulators should concern themselves far more with systemic risk than idiosyncratic risk of institutions; from that standpoint, it is exactly the worst behavior that is being encouraged by a "too large to fail" doctrine.
What would have happened without a Fed-organized bailout of Long-Term Capital? It remains an open question. An entirely private consortium led by Warren E. Buffett might have bought the fund, but capital markets might still have frozen because of the realization that bailouts were not guaranteed.

And Fed inaction might have had graver economic consequences, especially if a Buffett deal had fallen through. In that case, a rapid financial deleveraging would have followed, and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.
Of course, even if it would have been better than what happened — better than the counterfactual counterfactual — regulators would surely have been criticized for the decision.

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