Beware Bailouts

by James Surowiecki

In August of 1998, disaster loomed for the U.S. economy. Panic among investors after Russia defaulted on its sovereign bonds led to plummeting stock prices and a freeze on global credit markets. The hedge fund Long-Term Capital Management saw its multibillion-dollar portfolio evaporate in days, and investors pulled their money from any asset that had even a tinge of risk. But then the Federal Reserve came to the rescue, slashing interest rates three times in the space of a few weeks and pouring huge amounts of cash into the financial system. The stock market rebounded, and the economy boomed. Early the next year, Time put the Fed chairman, Alan Greenspan, on its cover, along with the Treasury officers Robert Rubin and Larry Summers, with the headline “The Committee to Save the World.”

Nine years later, it’s been another terrible August on Wall Street. The meltdown of the market in subprime loans, which over the past six months has led to the shuttering of many home lenders and mortgage brokers, has spilled over into the broader credit market. Bankers and bondholders are demanding very high interest rates for risky loans and, in some cases, refusing to lend money at all. Hedge funds and brokerages that invested in subprime securities have found themselves stuck with billions in assets that no one wants to buy, while, in the past month, panicked investors have sent the stock market down almost ten per cent. As anxiety over a global credit crunch spread, Wall Street implored an apparently reluctant Fed to rescue investors once again. And, last Friday, that’s exactly what it did, cutting the discount rate—the rate at which it lends to banks—by half a point. In response, investors sent the stock market soaring.

For anyone with a 401(k), it was hard not to greet the Fed’s move with relief. But the short-term relief comes with a long-term cost. Money managers created the current turmoil by failing to take risk seriously, enabling borrowers with sketchy credit records to borrow money nearly as cheaply as blue-chip companies. In the past weeks, managers had been paying for their folly. The Fed’s decision to flood the system with cheap money will create a textbook case of what’s usually called moral hazard: insulating fund managers from the consequences of their errors will encourage similarly risky bets in the future.

Now, you can take a fear of moral hazard, and a desire to see foolishness punished, too far. In times of real crisis, we don’t want the Fed to follow the advice that Herbert Hoover says he got from Andrew Mellon during the Great Depression: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. . . . Purge the rottenness out of the system.” When the health of the U.S. economy is under serious threat, the Fed should act. But in this case it’s far from clear that the turmoil was an actual menace to the underlying economy of the U.S. Bailing out hedge-fund managers was great for Wall Street, but it may not have been such a good deal for Main Street.

Wall Street so dominates our image of the U.S. economy these days that it’s easy to assume that what’s bad for the Street must be bad for everyone else. But, while it’s true that a complete market meltdown would have disastrous effects on the economy as a whole, market downturns like those of the past few weeks often have only a small effect on businesses and consumers. In part, that’s because much of what happens on Wall Street consists of the shuffling of assets among various well-heeled players, rather than anything that’s fundamental to the smooth functioning of the U.S. economy. (The economy did fine before the advent of hedge funds and private-equity funds, and would probably do fine in their absence.) Similarly, while stock-market tumbles are always painful, they have no concrete impact on most American consumers, who own little or no stock. (In any case, the S. & P. 500 is still up ten per cent over the past year, which hardly suggests imminent disaster.) And, in the short run, they’re irrelevant to most corporations, too, since few companies actually use the stock market to raise capital.

The bond and loan markets do, of course, matter quite a bit to companies and to individuals, because no economy can run without a steady supply of credit. But, although standards for corporate lending have tightened in recent weeks, and interest rates on corporate bonds may have risen steadily, they’re still low by historical standards, while the rates for most traditional mortgages have barely risen. That may be why the economy as a whole shows few signs of imminent doom. Corporate profits continue to go up. Unemployment is still relatively low, and wages in the last quarter rose at a surprisingly fast rate. Likewise, in July, retail sales were healthier than expected, and industrial production was reasonably brisk.

That’s not to say that the economy has suffered no fallout from the subprime collapse. The fall in housing prices, the drying up of new construction, and the sharp rise in foreclosures in many areas are having a serious impact on employment and economic growth. But these are not problems that the Fed’s action will solve. Cutting the discount rate is not going to help subprime borrowers get new loans, nor will it get the housing market moving again. What it will do is reassure investors and save some money managers from well-deserved oblivion. It may be that the risk of a full-fledged credit crunch was high enough to make this worth doing. But there is something unseemly about watching the avatars of free-market capitalism rely on the government to pay for their bad bets. And there is something scary about contemplating the even bigger bets they’ll make in the future if they know that the Fed is there to bail them out. ♦