In seizing Bear Stearns, then Fannie Mae and Freddie Mac, and now insurance giant AIG, federal policy-makers appropriately used their authority to stabilize the markets and protect the American economy from systemic risk and collapse. However, the government appropriately drew the line at not bailing out Lehman Brothers after concluding its demise did not present a sufficient risk to the system, had it failed.
Recent events have brought to the fore the kinds of financial nightmares policy-makers had hoped they never would have to face: saving very large financial institutions (and their creditors and possibly shareholders indirectly) because those firms’ failures would cause much greater financial and economic damage to the U.S. economy as a whole, as well as economies abroad. In my view, most policy-makers, businesses and experts have always believed that in an emergency the government would be forced to do this, and now they have confirmed those expectations and made the “too big to fail” policy explicit.
What is so shocking to many is that these worst case scenarios—something that few ever expected to play out—have actually materialized. But the good news is that we have learned from the past: while Depression-era policy makers watched idly while events spiraled out of control, today’s policy-makers have recognized the need for swift action to contain the damage. The hope is that it will be enough.
Unfortunately, given the number of unforeseen events we have witnessed so far, it would be surprising if we have reached the end of large firm failures. The mortgage crisis is now spilling over into areas of the credit markets. We simply don't know the extent of additional losses all this will cause, nor who will suffer them. The Fed's balance sheet isn't what it used to be, so there is a limit to its ability to continue coming to the rescue—without printing more money and fueling inflation, or in a last resort, borrowing from central banks elsewhere. If push comes to shove, though, the Fed will likely print what is necessary to finance any rescues it believes are needed to contain risks to the financial system.
Policy-makers have applied tourniquets as needed, but longer-term questions remain about how to preventing future crises. The Treasury Department's Blueprint issued last March provides a good list of the topics—improving the mortgage origination and securitization processes, the regulation of banks and other financial institutions, and a reexamination of accounting rules, for starters. The next Administration, the Congress and regulators clearly will have a full plate of issues to resolve. They won't get much sleep.