Beware Bailouts.(The Talk of the Town)(subprime loans and other assets stock in financial markets)

In August of 1998, disaster loomed for the U.S. economy. Panic among investors after Russia defaulted on its sovereign bonds led to plummeting stock prices and a freeze on global credit markets. The hedge fund Long-Term Capital Management saw its multibillion-dollar portfolio evaporate in days, and investors pulled their money from any asset that had even a tinge of risk. But then the Federal Reserve came to the rescue, slashing interest rates three times in the space of a few weeks and pouring huge amounts of cash into the financial system. The stock market rebounded, and the economy boomed. Early the next year, Time put the Fed chairman, Alan Greenspan, on its cover, along with the Treasury officers Robert Rubin and Larry Summers, with the headline "The Committee to Save the World."

Nine years later, it's been another terrible August on Wall Street. The meltdown of the market in subprime loans, which over the past six months has led to the shuttering of many home lenders and mortgage brokers, has spilled over into the broader credit market. Bankers and bondholders are demanding very high interest rates for risky loans and, in some cases, refusing to lend money at all. Hedge funds and brokerages that invested in subprime securities have found themselves stuck with billions in assets that no one wants to buy, while, in the past month, panicked investors have sent the stock market down almost ten per cent. As anxiety over a global credit crunch spread, Wall Street implored an apparently reluctant Fed to rescue investors once again. And, last Friday, that's exactly what it did, cutting the discount rate--the rate at which it lends to banks--by half a point. In response, investors sent the stock market soaring.

For anyone with a 401(k), it was hard not to greet the Fed's move with relief. But the short-term relief comes with a long-term cost. Money managers created the current turmoil by failing to take risk seriously, enabling borrowers with sketchy credit records to borrow money nearly as cheaply as blue-chip companies. In the past weeks, managers had been paying for their folly. The Fed's decision to flood the system with cheap money will create a textbook case of what's usually called moral hazard: insulating fund managers from the consequences of their errors will encourage similarly risky bets in the future.

Now, you can take a fear of moral hazard, and a desire to see foolishness punished, too far. In times of real crisis, we don't want the Fed to follow the advice that Herbert Hoover says he got from Andrew Mellon during the Great Depression: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. . . . Purge the rottenness out of the system." When the health of the U.S. economy is under serious threat, the Fed should act. But in this case it's far from clear that the turmoil was an actual menace to the underlying economy of the U.S. Bailing out hedge-fund managers was great for ...