Tyler Cowen says maybe the “Committee to Save the World” deserves a share of the blame for our current predicament:
Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital’s shareholders were wiped out, but none of the creditors took losses.
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. […]
The Long-Term Capital episode looks small when viewed against all of that. 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.
I might put this differently. When LTCM was on the verge of collapse, it seemed to regulators that allowing it to collapse would have unacceptable consequences for the world economy. Therefore, they had to leap into action to prevent it from defaulting on its debts. 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.
But if you are going to take a libertarian line on financial regulation then the only reasonable option is to follow Cowen and take an anti-intervention line on bailouts. The combination of lax oversight and implicit federal guarantees has been disastrous.