Tuesday, 29 March 2011

EconTalk this week

Vincent Reinhart of the American Enterprise Institute talks with EconTalk host Russ Roberts about the government interventions and non-interventions into financial markets in 2008. Conventional wisdom holds that the failure to intervene in the collapse of Lehman Brothers precipitated the crisis. Reinhart argues that the key event occurred months earlier when the government engineered a shotgun marriage of Bear Stearns to JP Morgan Chase by guaranteeing billion of Bear's assets and sending a signal to creditors that risky lending might come without a cost. Reinhart argues that there is a wider menu of choices available to policy makers than simply rescue or no rescue, and that it is important to take action before the crisis comes to a head.

For a summary of Reinhart's view of the financial crisis see A Year of Living Dangerously: The Management of the Financial Crisis in 2008, Journal of Economic Perspectives, volume 25, number 1, winter 2011, pages 71–90:
A more appropriate narrative of the financial crisis that exploded in September 2008 would begin with how the Corps of Financial Engineers—comprising chiefly the Secretary of the Treasury, the Chairman of the Federal Reserve, and the President of the Federal Reserve Bank of New York—inserted the government into the resolution of the investment bank Bear Stearns in March 2008. The financial authorities interpreted the death throes of the mid-sized investment bank as a problem of systemic importance and, with an ill-considered and unprecedented decision, intervened in a way that protected the uninsured creditors of Bear Stearns and raised the expectations of future bailouts. When the same Corps of Financial Engineers then failed to intervene in September 2008, Lehman Brothers entered bankruptcy. The resulting market seizure was in large part a counter-reaction based on the prior official decision just six months earlier to protect Bear Stearns.

Many observers, including the Secretary of the Treasury at that time Hank Paulson (2010) and Federal Reserve Chairman Ben Bernanke (2010), have looked back at the decision to let Lehman slip into bankruptcy on September 14, 2008, with regret and bemoaned the lack of tools available to them at the time to prevent the outcome. I will argue that Lehman’s failure had widespread consequences because of the false hopes engendered by Fed support to Bear Stearns. Instead of asking “Why not save Lehman?” a more useful and consequential question is “Why save Bear Stearns?”

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