Great Depression Online Archive Issue:

A High Stakes Research Experiment

Great Depression Online
Long Beach, CA
September 19, 2008

Inside This Issue You Will Discover…

*** AIG Bailout
*** The Lender of Last Resort
*** A High Stakes Research Experiment
*** And More

AIG Bailout

Another financial bombshell exploded Tuesday evening in the form of an $85 billion dollar bailout of insurance giant AIG.

“In a bid to save financial markets and economy from further turmoil,” reported AP, “the U.S. government agreed Tuesday to provide an $85 billion emergency loan to rescue the huge insurer AIG.

“The problems at AIG stemmed from its insurance of mortgage-backed securities and other risky debt against default.”

AIG, regrettably, had soured its balance sheet insuring feeble mortgages.  In short, AIG was heavy into Credit Default Swaps (CDSs), which are essentially insurance policies that they sold to buyers of Collateralized Debt Obligations (CDOs).

The premiums made for a nifty business when the collateral – house prices – was rising.  It was like free money.  Of course, we all know, house prices don’t always go up…in fact, sometimes they go down.  And apparently, with this twist of fate, AIG’s finding it extraordinarily difficult to make good on their commitments.

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~~~~~~~~~~~~~~~~~~~~~~~~~

Several strings were attached to the deal…

“The Fed said in return for the loan, the government will receive a 79.9 percent equity stake in AIG.”

In other words, AIG’s being nationalized.

Still, financial markets didn’t take much comfort in the news…the DOW crashed 449.36 points on Wednesday.  Thursday morning the Federal Reserve announced they were injecting $55 billion into the financial system, yet the markets – after starting the day up – were again trending down.

But that was before Thursday afternoon, when the Bush administration announced a comprehensive financial rescue package…the markets loved the idea and the DOW promptly rallied to close the day up 410.03 points.

What gives?

The Lender of Last Resort

With all the blowups and bailouts going on, we decided to take our own advice and pulled out our copy of Charles Kindleberger’s classic Manias, Panics, and Crashes.  Turning to the discussion of the Lender of Last Resort, we read…

“The lender of last resort stands ready to halt a run out of real and illiquid financial assets into money by making more money available.  How much?  To whom?  On what terms?  When?  These constitute some of the dilemmas of the lender of last resort….  All these issues derive from the basic dilemma that if the market knows it is to be supported by a lender of last resort it will feel less (little? no?) responsibility for the effective functioning of money and capital markets during the next boom.  The public good of the lender of last resort weakens the private responsibility of ‘sound’ banking.  If, however, there is no authority to halt the disintermediation that comes with panics … the fallacy of composition takes command.  Each participant in the market, in trying to save himself, helps ruin all.”

A High Stakes Research Experiment

Whether you are for or against the idea of a lender of last resort we’ll reserve for another day.  Regardless, at this moment, the Federal Reserve and the U.S. Treasury are acting as the lender of last resort.

Will they restore confidence in financial markets?  Will they save the economy from a depression?  And if their actions continue to do little to alleviate the crisis…when do they throw in the towel and just let things happen?

We don’t know what the best thing to do considering the current circumstances is, we haven’t a clue.  Will one more bailout do the trick?  How about two more?  What about a comprehensive financial rescue package…will it work?

At the onset of the Great Depression, then Treasury Secretary Andrew Mellon advocated letting things crash…

“Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” he advised Hoover.

Indeed, this do nothing approach goes contrary to human nature…when we find problems, we fix them.  Yet, some things you just can’t bring about a solution to through government action.  It doesn’t matter if the government passes a law making the Gulf of Mexico a “Hurricane Free Zone,” hurricanes will still clobber the region every several years.

So too, throwing good money after bad through more and more bailouts may not fix the problem.  Who knows?  Maybe it’ll help cushion the fall.  Or perhaps, flooding the globe with paper money through endless bailouts could exacerbate it. 

It makes for an interesting research experiment, if only the stakes weren’t so high.

Sincerely,

M.N. Gordon
Great Depression Online

P.S.  We had a number of readers take our recommendation to grab a copy of Charles Kindleberger’s classic, Manias, Panics, and Crashes – A History of Financial Crisis.  Don’t delay.  For in this masterpiece you may learn something that will help you preserve your life savings and dignity in the process.  Learn more here: Manias, Panics, and Crashes - A History of Financial Crisis.

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