Not more creampuffs

The subtitle of Kenneth Rogoff's recent article in the Washington Post says a lot, No More Creampuffs: The Government Is Willing to Let Wall Street Firms Fail. That's Good. And it is good.

Rogoff writes,

This past weekend, the U.S. Treasury and the Federal Reserve finally made it abundantly clear that they won't bail out every significant financial firm in America. Certainly this came as a rude shock to many financiers. In allowing the nation's fourth-largest investment bank, Lehman Brothers, to file for bankruptcy, and by forcefully indicating that they are prepared to see even more bankruptcies, our financial regulators showed Wall Street that they are not such creampuffs after all.

It would have been better if they had let all of them go to the wall but I guess it's better late than never.

Rogoff continues

Letting a big investment bank go, as the Fed and Treasury did this weekend, was a calculated risk in a difficult situation. And the risks are very real. With the immense interconnectivity of the financial system, there really is no telling where the unprecedented failure of a big investment bank might lead. On the other hand, ponying up tens of billions in tax money, as the Federal Reserve did in March when another investment bank, Bear Stearns, collapsed, is no answer, either. With the housing market still weakening, with U.S. exports likely to suffer as the global economy falters and with unemployment rising, it is clear that simply bailing out Lehman Brothers would not stop the rot in the financial system.

In March, the Federal Reserve took on $29 billion in risky Bear Stearns assets. Bailing out Lehman probably would have involved at least as large a commitment. If such a maneuver could have put an end to the crisis, it might have been justified, but that is hardly the case with many other giants teetering. This is not to mention the trillions of dollars in liabilities the Treasury took on 10 days ago in bailing out the mortgage giants Fannie Mae and Freddie Mac. These alone will probably end up costing taxpayers $100 billion to $200 billion, assuming inflation-adjusted housing prices fall another 10 to 12 percent.

Rogoff ends by saying

But by placing some of the burden on the shareholders and bondholders of the big financial institutions, financial regulators have at least forced some discipline onto the system, making bankers and investors think twice before they once again head off to the races. By allowing firms that took excessive risks to fail, regulators also reduce the political pressure to overregulate the system in the aftermath of the crisis. Let's hope they hang tough for at least a little while longer.

Let's hope they hang tough forever.