Tyler Cowen has an interesting Times column arguing that the 1998 bailout of Long-Term Capital Management, the once high-flying hedge fund, is an important factor in the recent financial meltdown:
At the time, it may have seemed that regulators did the right thing. 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. ...
[I]t 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.
The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good. ...
Fed inaction might have had graver economic consequences, especially if a [Warren] Buffett deal had fallen through. In that case, a rapid financial deleveraging would have followed, and 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.
It's an intriguing point with lots of analytic insight, but ultimately a little off the mark I think. Cowen's argument hinges on the idea of moral hazard: By bailing out LTCM, we set a precedent that investors (or at least creditors) don't have to suffer the consequences of their bad decisions. This made them even more reckless during the following decade, leading to an even bigger collapse when the music finally stopped.
But would not bailing out LTCM have really solved our moral hazard problem? Stick with the scenario Cowen lays out and ask yourself what's likely to happen when the financial authorities let a hedge fund collapse and it triggers a recession? My sense is that a huge political backlash ensues, and said financial authorities get scapegoated (even if they made the right call on the merits). Unfortunately, that also sets a precedent--this one for financial authorities--which is that, if you want to avoid being run out of town, you can never allow a financial institution to collapse on your watch.
This, in turn, creates an even bigger moral hazard problem than the one you were trying to avoid. Even with the way things unfolded for LTCM, no future creditor could be sure they'd be bailed out because the regulator was still free to make a case by case judgment, as Cowen points out. But if LTCM's collapse had triggered a recession, future creditors would be certain they'd get bailed out if their losses threatened the economy. No future regulator would want to deal with the kind of political blowback they'd be courting otherwise.
If you don't believe me, just fast forward to the present. As one shrewd money manager recently observed to me, the flack Hank Paulson and Ben Bernanke took over the collapse of Lehman Brothers has basically ensured that no future Lehman Brothers will be allowed to collapse. Something tells me this person was not the only person on Wall Street to reach that conclusion.
The upshot, to me, is twofold: 1.) By the time a financial institution is so large/leveraged that its collapse would threaten the economy, it's almost certainly (but not definitely) going to be bailed out if starts to crater. This creates a moral hazard problem, but the alternative is worse in almost every respect. 2.) The trick is to prevent most institutions from becoming so large/leveraged that their collapse would threaten the economy, and to regulate the hell out of the rest.
Update: Matt Yglesias has some good thoughts about this, too.