Finally Paulson and Bernanke Did the Right Thing

Paulson and Bernanke finally moved to restore investor confidence by effectively underwriting or buying many of the bad loans that had been undermining the health of financial institutions in the US. The financial markets worldwide cheered with close to 10% jump in two days.

This behavior of the financial markets once again confirmed the importance of confidence. When confidence comes back, firms that otherwise would fail are saved. When confidence collapses, firms that otherwise were healthy could fail.

I had lamented Paulson's failure to act as a guarantor to facilitate the takeover of Lehman Brothers by potential buyers because that really rocked the financial market and triggered a "tsunami" across the world's financial markets. If this time around Paulson and Bernanke failed to act promptly, it is entirely possible that the US and the world slip into the second Great Depression.

For now the world is saved. I am sure despite the cost in terms of direct taxpayers' money, taxpayers will thank Paulson and Bernanke for what they did.

I hope, though, that they will still take necessary action against real moral hazard: i.e., whose who win big if their bets are right and have little to lose if their bets are wrong. If they are sincere about guarding moral hazard they should be after the decision makers who created the mess, and not the innocent savers both in the US and in the rest of the world.

Paulson Made a Mistake

In allowing the demise of Lehman Brothers instead of salvaging it with taxpayers’ money Paulson and his associates claim that this is to avoid moral hazard, so that risky investors will not be protected from the results of their own risky ventures. The fact, however, is that the risky ventures were undertaken by other people without the knowledge of the shareholders. It is ironic that the decision makers get away from dire consequences while the innocent suffer in the name of avoiding moral hazard. With Wall Street falling over 500 points it is clear that taxpayers are losing far more than what they possibly “ saved” if the government had stepped in to facilitate the orderly take-over of Lehman Brothers by the suitors. This is yet another instance of the lack of understanding about systematic effects or what I had called the ecology of market economy.

The fact of the matter is that global capitalism requires a good dose of common sense. Who in their right mind would believe that the mortgage loans are “backed” by collaterals, when borrowers have hardly any down-payment or equity in their homes in the first place? Who in their right mind would believe that the market can self-regulate, when market participants are subject to a conflict of interest. There is no need for a “financial engineering” degree to tell that we need effective safeguards when a few people are playing with huge sums of other people’s money. Without proper safeguards, it is not surprising that “rogue traders” like Jérôme Kerviel and Nick Leeson would take advantage of the loopholes that are there to benefit themselves. Without proper safeguards, we have seen fake transactions inflating balance sheets and yielding handsome fees to officials of some thrifts during the 80s contributing to the Savings and Loans Crisis in the US. Without proper safeguards, we have seen how the auditor conspired with company executives in the case of Enron.

The market place offers both crooks and innocent people opportunities. But the opportunities of the crooks are the risks of the innocent. Our choice is definitely not over having more versus having less regulation. Our choice is over appropriate regulation versus inadequate or inappropriate regulation. Some say that too much regulation stifles markets. The fact is that the right kind of regulation enables markets to run smoothly and fairly.