Economics

After Long Term Capital Management, The Deluge?

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Last week in the New York Times, reason contributor Tyler Cowen wonders if some of the thickest roots of the current crisis stretch back to the 1998 hedge fund bailout of Long Term Capital Management, which seemed to solidify some new game rules: don't worry about the soundness of those to whom you loan money. The details:

The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

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The Long-Term Capital episode looks small….[but] it was important precisely because the fund was not a major firm. At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn't previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.

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…..Fed inaction might have had graver economic consequences….the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.

In 1998, there was no collapsed housing bubble, the government's budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.

Cowen goes on to jab at the resurrected economic God of the Current Crisis, Keynes, who,

famously proclaimed that "in the long run we are all dead." From the vantage point of 1998, today is indeed the "long run." We're not quite dead, but we are seriously ailing. As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next "long run," too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.