What Should Uncle Sam Do?

While our economy has substantial underlying strengths—its flexibility and dynamism, healthy corporate balance sheets and strong exports—the risk of today's serious difficulty continuing for an extended time, and perhaps worsening, is sufficient to continue calling for a highly proactive policy response. The fiscal-stimulus and GSE legislation earlier this year, the various actions of the Federal Reserve Board and the intervention of the Federal Reserve Board and Treasury to prevent the failure of Bear Stearns were all constructive. The actions on Bear Stearns were necessary because it was extensively interconnected with the rest of the global financial system, so that its failure could have led to serious crisis. Fannie Mae and Freddie Mac are even more deeply interconnected to the rest of the financial system, through the massive holdings of mortgage securities they've guaranteed, through their debt, and through the critical role Fannie and Freddie play in the ongoing economy. Thus, Treasury should be given the capacity to act if it concludes that is necessary. Moreover, the authority should be open-ended—both to provide the confidence to the markets that would reduce the probability of that authority being needed and to make that authority effective if it is needed.

In addition, pending legislation to facilitate mortgage renegotiation should be enacted. Foreclosure proceedings involve enormous economic inefficiency, and facilitating renegotiations would increase economic efficiency, reduce risk to our economy and help many struggling families.

The Bear Stearns and Fannie Mae-Freddie Mac situations manifest a larger reality: in today's global system, every major financial company has vast contractual obligations to other companies throughout the world. This is largely as a result of the exponential increase in financial engineering that has created contractual commitments in the form of derivatives and other similar instruments. If any of these systemically critical institutions were to go into default, the consequences for the rest of the system could be severe or worse. For the immediate future, that means policymakers must act to prevent such default where the threat to the system is great enough, while at the same time minimizing the moral-hazard consequences. And, for the longer term, this new reality means that our financial system should be reformed: to provide comprehensive and greatly increased margin and capital requirements for those products of financial engineering; to extend the bank regulatory regime to other systemically significant institutions; to provide sensible guidelines with respect to off-balance-sheet financing, and quite possibly to move from the mark-to-market accounting that has contributed so greatly to market disorder in the current situation to an accounting methodology more like the reserve accounting used for bank loans.

Our market-based financial system has contributed greatly to our economy, and is far preferable to a government-directed system. However, we must address immediate threats to our economy, and we must act on the lessons of the current crisis to reduce systemic risk in the future. The objective is not to eliminate or even minimize risk, but rather to optimize the balance between increasing protection and preserving the benefits of our free-market system. Moreover, all these changes, both in the short term and the long term, are technically very complicated and involve difficult trade-offs. But not acting is also a decision, and we would be far better off by moving forward than maintaining the status quo.

Failing to Learn the Lessons

Peter Wallison , general counsel for the Treasury and the White House in the Reagan administration, now Arthur F. Burns fellow in financial policy at the American Enterprise Institute

Assuming that congress adopts the Paulson plan, the Fannie MAE and Freddie Mac crisis is likely to fade away. The secretary's package assured the markets that the U.S. government stands behind Fannie and Freddie, and hence assures a continuing flow of the funds they need to operate. This will enable them to survive until and unless their regulator declares that they are insolvent, and this is unlikely to happen if housing prices stabilize over the next three or four months. Of course, if housing prices continue to deteriorate, Fannie and Freddie will both be in jeopardy of insolvency, in which case the government will have to step in and take control of them. But this I assess as unlikely.

With Fannie and Freddie successfully, if temporarily, tucked away, the greatest danger we face is failing to learn the lesson they teach—that government backing for a private, shareholder-owned company will inevitably come to a bad end. Government backing creates moral hazard, inducing lenders to shed the wariness they usually display in lending to an ordinary company; the easier money thus obtained, and the lack of market discipline, permits managements to take extraordinary risks in pursuit of extraordinary profits. As with Fannie and Freddie and the S&Ls before them, these risks turn into losses that the taxpayers must absorb.