The American Mind

Long time market liberal Martin Wolf thinks the Federal Reserve-financed Bear Stearns buyout has ushered the global economy into a new age of regulation:

Remember Friday March 14 2008: it was the day the dream of global free- market capitalism died. For three decades we have moved towards market-driven financial systems. By its decision to rescue Bear Stearns, the Federal Reserve, the institution responsible for monetary policy in the US, chief protagonist of free-market capitalism, declared this era over. It showed in deeds its agreement with the remark by Josef Ackermann, chief executive of Deutsche Bank, that “I no longer believe in the market’s self-healing power”. Deregulation has reached its limits.

Mine is not a judgment on whether the Fed was right to rescue Bear Stearns from bankruptcy. I do not know whether the risks justified the decisions not only to act as lender of last resort to an investment bank but to take credit risk on the Fed’s books. But the officials involved are serious people. They must have had reasons for their decisions. They can surely point to the dangers of the times – a crisis that Alan Greenspan, former chairman of the Federal Reserve, calls “the most wrenching since the end of the second world war” – and the role of Bear Stearns in these fragile markets.

Mine is more a judgment on the implications of the Fed’s decision. Put simply, Bear Stearns was deemed too systemically important to fail. This view was, it is true, reached in haste, at a time of crisis. But times of crisis are when new functions emerge, notably the practices associated with the lender-of-last-resort function of central banks, in the 19th century.

The implications of this decision are evident: there will have to be far greater regulation of such institutions. The Fed has provided a valuable form of insurance to the investment banks. Indeed, that is already evident from what has happened in the stock market since the rescue: the other big investment banks have enjoyed sizeable jumps in their share prices (see chart below). This is moral hazard made visible. The Fed decided that a money market “strike” against investment banks is the equivalent of a run on deposits in a commercial bank. It concluded that it must, for this reason, open the monetary spigots in favour of such institutions. Greater regulation must be on the way.

Politically Wolf is right. This Presidential cycle we’ve seen the rise of economic populism from John Edwards and Mike Huckabee. We also heard Sens. Clinton and Obama deride NAFTA. Tough economic times open up opportunities for politicians to successfully push for more government interference in the economy.

My biggest concern is about moral hazard. In Bear’s case I think losing over 80% of one’s stock value discourages risky behavior. Kevin Drums disagrees and uses the rise of investment bank stock prices as evidence. I see those price increases as the market feeling more confident in the financial industry as a whole. The systemic problem with Bear was it was involved in so many trades that it going under in a drawn-out bankruptcy would have put a big wrench in the financial markets. The Fed’s efforts let JP Morgan swallow Bear and allow it to continue trading. It is that the stock market think the Fed will bail them out of their losses; it’s that the Fed helped keep the financial markets working.

“The Rescue of Bear Stearns Marks Liberalisation’s Limit“