On Sunday of this past week Merrill Lynch agreed to sell itself to Bank America, on Monday Lehman Brothers, a venerable major Wall Street investment bank, went into the largest bankruptcy in American history, while Tuesday saw the federal government partial takeover of AIG insurance company, one of the largest business insurers in the world. Instead of calming financial markets, these moves helped precipitate a complete collapse on Wednesday and Thursday of the market for short-term capital. It became virtually impossible to borrow money, and carrying costs shot through the roof. The Libor, or London interbank, lending rate sharply increased, as banks worldwide were reluctant to lend money. The rate on American treasury bills, and on short-term interest rates in Japan, even became negative for a while, as investors desperately looked for a safe haven in short term government bills.
The Treasury" extended deposit insurance to money market funds-without the $100,000 limit on deposit insurance. The Fed also began to take lower grade commercial paper as collateral for loans to investment and commercial banks, and the Treasury encouraged Fannie Mae and Freddie Mac to continue to purchase mortgage backed securities.
Is this the final "Crisis of Global Capitalism"- to borrow the title of a book by George Soros written shortly after the Asian financial crisis of 1997-98? The crisis that kills capitalism has been said to happen during every major recession and financial crisis ever since Karl Marx prophesized the collapse of capitalism in the middle of the 19th century. Although I admit to having greatly underestimated the severity of this financial crisis, I am confident that sizable world economic growth will resume under a mainly capitalist world economy. Consider, for example, that in the decade after Soros' and others predictions of the collapse of global capitalism following the Asian crisis in the 1990s, both world GDP and world trade experienced unprecedented growth. The South Korean economy, for example, was pummeled during that crisis, but has had significant economic growth ever since. I expect robust world economic growth to resume once we are over the current severe financial difficulties.
Was the extent of the Treasury's and Fed's involvement in financial markets during the past several weeks justified? Certainly there was a widespread belief during this week among both government officials and participants in financial markets that short-term capital markets completely broke down. Not only Lehman, but also Goldman Sachs, Stanley Morgan, and other banks were also in serious trouble. Despite my deep concerns about having so much greater government control over financial transactions, I have reluctantly concluded that substantial intervention was justified to avoid a major short-term collapse of the financial system that could push the world economy into a major depression.
Still, we have to consider potential risks of these governmental actions. Taxpayers may be stuck with hundreds of billions, and perhaps more than a trillion, dollars of losses from the various insurance and other government commitments. Although the media has amde much of this possibility through headlines like "$750 billion bailout", that magnitude of loss is highly unlikely as long as the economy does not fall into a sustained major depression. I consider such a depression highly unlikely. Indeed, the government may well make money on its actions, just as the Resolution Trust Corporation that took over many saving and loan banks during the 1980s crisis did not lose much, if any, money. By buying assets when they are depressed and waiting out the crisis, there may be a profit on these assets when they are finally sold back to the private sector. Making money does not mean the government involvements were wise, but the likely losses to taxpayers are being greatly exaggerated.
Future moral hazards created by these actions are certainly worrisome. On the one hand, the equity of stockholders and of management in Fannie and Freddie, Bears Stern, AIG, and Lehman Brothers have been almost completely wiped out, so they were not spared major losses. On the other hand, that makes it difficult to raise additional equity for companies in trouble because suppliers of equity would expect their capital to be wiped out in any future forced governmental assistance program. Furthermore, that bondholders in Bears Stern and these other companies were almost completely protected implies that future financing will be biased toward bonds and away from equities since bondholders will expect protections against governmental responses to future adversities that are not available to equity participants. Although the government was apparently concerned that foreign central banks were major holders of the bonds of the Freddies, I believe it was unwise to give them and other bondholders such full protection.
The full insurance of money market funds at investment banks also raises serious moral hazard risks. Since such insurance is unlikely to be just temporary, these banks will have an incentive to take greater risks in their investments because their short-term liabilities in money market funds of depositors would have complete governmental protection. This type of protection was a major factor in the savings and loan crisis, and it could be of even greater significance in the much larger investment banking sector.
Various other mistakes were made in government actions in financial markets during the past several weeks. Banning short sales during this week is an example of a perennial approach to difficulties in financial markets and elsewhere; namely, "shoot the messenger". Short sales did not cause the crisis, but reflect beliefs about how long the slide will continue. Trying to prevent these beliefs from being expressed suppresses useful information, and also creates serious problems for many hedge funds that use short sales to hedge other risks. Their ban can also cause greater panic in other markets.
Potential political risks of these actions are also looming. The two Freddies should before long be either closed down, or made completely private with no governmental insurance protection of their lending activities. Their heavy involvement in the mortgage backed securities markets were one cause of the excessive financing of home mortgages. I fear, however, that Congress will eventually recreate these companies in more or less their old form, with a mission to continue to artificially expand the market for mortgages.
New regulations of financial transactions are a certainty, but whether overall they will help rather than hinder the functioning of capital markets is far from clear. For example, Professor Shimizu of Hitotsubashi University has recently shown that the Bank of International Settlement (BIS) regulation on the required minimum ratio of bank capital to their assets was completely misleading in predicting which Japanese banks got into trouble during that country's financial crisis of the 1990s. Other misguided regulations, such as permanent restrictions on short sales, or discouragement of securitization of assets, will both reduce the efficiency of financial markets in the United States, and they will shift even larger amounts of financial transactions to London, Shanghai, Tokyo, Dubai, and other financial centers.
Finally, the magnitude of this crisis must be placed in perspective. Although it is the most severe financial crisis since the Great Depression of the 1930s, it is a far far smaller crisis, especially in terms of the effects on output and employment. The United States had about 25 percent unemployment during most of the decade from 1931 until 1941, and sharp falls in GDP. Other countries experienced economic difficulties of a similar magnitude. American GDP so far during this crisis has essentially not yet fallen, and unemployment has reached only about 61/2 percent. Both figures are likely to get considerably worse, but they will nowhere approach those of the 1930s.
These are exciting and troubling economic times for an economist-the general public can use less of both! Financial markets have been seriously wounded, and derivatives and other modern financial instruments have come under a dark cloud of suspicion. That suspicion is somewhat deserved since even major players in financial markets did not really understand what they were doing. Still, these instruments have usually been enormously valuable in lubricating asset markets, in furthering economic growth, and in creating economic value. Reforms may well be necessary, but we should be careful not to throttle the legitimate functions of these powerful instruments of modern finance.