Reckless Bailouts

The Washington Post, Tuesday, September 29, 1998; Page A17

The principle behind welfare reform was simple: If you pay people when they don't work, then they don't have an incentive to get a job. The 1996 law cut them off, and since then, millions have left the public dole.

Economists call the principle behind welfare reform "moral hazard." When people are insured, or protected against the consequences of destructive actions, they are more likely to take those destructive actions. Thus, if able-bodied welfare mothers know they'll get monthly checks, they're less likely to work.

But in America today, there's a double standard. A rule that applies to welfare mothers doesn't apply to politically connected corporations, rich speculators and irresponsible nations. Over and over, when powerful people and institutions get into trouble, the government bails them out.

The latest example is a Greenwich, Conn., hedge fund called Long-Term Capital, Ltd. (LTC), which was founded by John Meriwether, a "master of the universe" at Salomon Brothers, along with two Nobel Prize winners, a former Federal Reserve vice chairman and other partners whom Business Week called the "dream team."

Using as much as $100 billion in borrowed money, Long-Term Capital made some disastrously stupid investments and teetered last week on the brink of failure.

What should happen to a firm that makes terrible bets on esoteric markets? It should go bust, of course. Its partners and investors should suffer swift and onerous losses—at the very least as a signal to others to stay away from risky investments in the future.

Instead, Long-Term Capital is being rescued—not with government money (thank heaven for small favors) but through not-so-subtle pressure placed by government regulators on banks and investment firms to cough up $3.5 billion. It's a classic case of moral hazard run wild.

Paul Volcker, the former chairman of the Federal Reserve, was justifiably outraged: "Why should the weight of the federal government be brought to bear to help a private investor?" Good question.

The rescuers were brought together last week by the New York Fed at the same time that Alan Greenspan was hinting in Congress that the Fed would cut interest rates.

The Fed's "official sponsorship" (Volcker's term) of the rescue was the result, said a Fed spokesman, of its "concerns about the good working of the marketplace, large risk exposure and the potential for a disruption of payments." In other words, the failure of Long-Term Capital posed a systemic risk; it could set off a cascade of other failures, leading to a sharp decline in bond and stock prices and perhaps bankruptcies.

I am skeptical the effects would be so dire. Yes, some bonds might plummet, but that hurts current owners of those bonds. Other investors could benefit by being able to buy at the lower prices. Why should the Fed prevent them?

The truth is that no one knows what would have happened in the short-term if LTC had been allowed to fail. In the longer term, the effects are only too obvious: The rescue will encourage more irresponsible risk-taking by investors, just as the International Monetary Fund's bailout of Mexico encouraged investors to make inappropriately risky investments in emerging markets in Asia, leading to more IMF bailouts and a new moral-hazard cycle.

Perhaps the Fed did dampen systemic risk in the LTC case, but as Caroline Baum of Bloomberg Business News reported Friday, "Traders seem to be taking a different message away from the whole affair. They see an increase in moral hazard, with lenders making increasingly risky bets with the knowledge that someone will bail them out, as the doctrine of 'too big to fail' spreads from financial institutions to corporations to countries to private investors."

But we don't need to look to Mexico or Greenwich for examples of moral hazard run wild. Look to Capitol Hill, where a bill is now racing through Congress that would bail out companies that made imprudent bids for wireless telephone licenses.

The firms bid too high in a 1996 FCC auction. At the very least, it seems, they should lose the $1.3 billion they put up in down payments. But, instead, the House Commerce Committee on Thursday unanimously approved a deal that lets them renege on their bid obligations and get full refunds on what they've already paid the government.

Not only is this bailout grossly unfair, it will also encourage reckless behavior in future auctions. And, speaking of reckless behavior: There's a parallel to be drawn between moral hazard in the LTC, wireless and IMF cases and moral hazard in the current scandal involving President Clinton.

Americans worry, for instance, that impeaching and convicting Clinton could hurt the economy and our world standing. This is a legitimate concern—but I'm more afraid of moral hazard. If we let powerful people get away with doing bad things, they will not only do them again and again, but encourage others to follow their example.