It seemed as if the global economy were headed for the kind of crash we haven't seen since 1929. All the elements for a great financial meltdown and economic depression were in place last week—choked-off credit lines, massively leveraged firms, assets gone bad, sinking mortgages, panicked consumers and paralyzed companies. "What is different," says Harvard economic historian Niall Ferguson, "is that then the federal government and the Federal Reserve did all the wrong things. Now they're mostly doing the right things."
As of this writing, we don't know the details of the plan that is being crafted by Henry Paulson and Ben Bernanke to restore confidence in the U.S. financial markets. It is impossible to be certain that it will work. But the administration and the Federal Reserve were right to intervene in a large and systemic manner. Modern capitalism depends on credit, and credit depends on confidence. By the middle of last week, fear was pervasive and no one was ready to lend money to anyone for any purpose. It turned out that only government intervention could change this psychological paralysis. The lesson of the almost 100 (smaller) financial crises of the past three decades is that only government intervention can stabilize the system when it chokes.
The first task remains to bolster confidence. The next is to devise a workable and flexible plan to dispose of the mountains of assets that the government is taking over. Then, after some thought and analysis, should come the fixes needed to better structure America's massive and complex financial markets.
Some problems require more regulations. Firms that are deemed too large to fail should also be deemed too large to be leveraged at 35 to 1. Some problems require better regulations. For instance, the rule forcing financial institutions to mark their assets down to "market prices"—even when these are distressed prices and firms do not intend to sell the assets any time soon—created a crazy downward spiral. Still other problems require less state intervention. Why should the government insure Fannie Mae's risky profit-seeking behavior?
This crisis should put an end to false debates about government versus markets. Governments create markets, and markets can exist only with regulation. If you want to be truly free of regulation, try Haiti or Somalia. The real trick is to craft good regulations that allow markets to work well. No regulatory structure will be perfect, none will eliminate risk, nor should they. At best they can tame the wildest gyrations of the market economy while maintaining its efficiency.
Washington may have come late to the rescue. Bernanke is a brilliant man, but more professor than activist in his temperament. Paulson was plainly uncomfortable with having the government bailing out private firms. The Democrats in Congress were reluctant to put up taxpayer dollars. But to be fair, these were massive moves, not to be taken lightly. The government has now nationalized an investment bank, the world's largest insurer and 50 percent of the country's mortgage market, in addition to hundreds of billions of dollars' worth of bad financial assets. And without last week's meltdown there would have been no chance of any broad bailouts getting through Congress, whether led by Republicans or Democrats.
But having faced the abyss, the system has now clicked into high gear. In Paulson, America is extremely fortunate to have a man of tremendous intelligence, drive and pragmatism, who will engage in "bold and persistent experimentation" until the job is done. Bernanke has the knowledge and wisdom that will be needed to plan the longer-range solutions. Congress is acting in a responsible and nonpartisan fashion. Barack Obama has thrown his support behind the Bush administration's efforts.
Often in the past year we have watched markets behave in ways that they were not supposed to, but last week we saw government behave as it should.