Here is my latest NYT column. It starts as follows:
The financial crisis is a result of many bad decisions, but one of them hasn’t received
enough attention: the 1998 bailout of the Long-Term Capital Management
hedge fund. If regulators had been less concerned with protecting the
fund’s creditors, our current problems might not be quite so bad.
Bear Stearns, Merrill Lynch, and Lehman Brothers were all major creditors of LTCM. Given that regulation is inevitably imperfect, and cannot foresee or prevent every firestorm in advance, this was one chance to send a very stern message to those creditors. Perhaps no LTCM bailout would have meant dire consequences at the time, but still:
…Fed inaction might have had graver economic consequences,
especially if a 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. 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.
I’ve been reading much about LTCM in recent times, and in so many ways it was a micro- dress rehearsal for our later problems. This column also criticizes the current now-standard practice of "regulation by deal."
Addendum: Matt Yglesias adds: " At the time I think everyone was clear on the idea that if
institutions such as LTCM were “too big to fail” that they had to be
brought into a regulatory umbrella. But as soon as it was clear that
disaster had been averted, a lot of people became complacent about
operationalizing this determination to expand the scope of regulation
and some of the key participants – especially Alan Greenspan – in the
bailout only redoubled their opposition to regulation."