The Fed's Bailout Balancing Act Could Work

The Federal Reserve and U.S. Treasury Dept. might contain the credit crisis and spur economic recovery with just enough discipline and aid

By refusing to pony up more money to save Lehman Brothers (LEH), the U.S. government took a high-stakes gamble over the weekend of Sept. 12-14. After committing $29 billion to the teardown of Bear Stearns and up to $200 billion in the nationalization of Fannie Mae (FNM)and Freddie Mac (FRE), Washington looked at the plight of Lehman and just said no. Yet, not two days later, the Federal Reserve gave troubled insurer American International Group (AIG) an $85 billion loan, effectively taking over the company.

Who survives and who doesn't? Those decisions could usher in the end of the credit crisis—or they might mark the end of any hope for an economic recovery next year.

This new uncertainty in the outlook reflects the cost of stepping back from moral hazard. Policymakers know that moral hazard—which arises when institutions don't bear the full consequences of their actions—can never be eliminated. Rather, they view the problem as a trade-off between the risk that government bailouts could encourage financial imprudence and the danger that without them, an event such as the failure of AIG could collapse the system. In the case of Lehman, the Fed and Treasury took a gamble that Lehman's failure could be a major step toward healthier financial markets. As for AIG, the risk to the system was simply too great.

Events are still fluid, but the economic impact of these latest financial shocks should be modest as long as their ripple effects don't erode the capital bases of sounder institutions. Such a spillover, a big risk in the case of AIG, would severely crimp the availability of credit at a time when the economy is weak—partly as a result of already tight credit conditions.

The Fed is front and center in the efforts to contain the damage, not only to the financial system but also to the economy. It continues to treat the two problems with two different medicines: applying direct help for the credit market's woes via its innovative lending facilities and the broad power of interest rate cuts for the ailing economy.

This two-pronged approach was clear from the Fed's failure to acquiesce to market desires for a rate cut on Sept. 16. It held its target rate at 2%, believing past rate cuts are sufficient to promote growth. Meanwhile, the Fed's lending programs, including additional enhancements on Sept. 14, are aimed at assuring liquidity at both depository institutions and investment banks. Those funds helped contain the wider damage from Lehman's fall, but those programs are not available to AIG because it is an insurer, not a bank. That they allowed Lehman to fail suggests policymakers felt they had sufficient liquidity in place to protect the system.

The new question for the Fed is how badly the latest upheaval will harm the economy by cutting further into the availability of credit to households and businesses. Companies will be even more hesitant to commit money to capital projects and new hires, and household balance sheets will take another blow from sagging stock prices. Even before the current storm, August reports on consumer spending, housing starts, industrial production, and employment showed the economy had already weakened further.

The Fed's Sept. 16 statement showed that policymakers were still seeking the right balance for its more traditional trade-off—the one between stifling economic growth and stoking inflation. While giving equal weight to those two worries, saying they were each "of significant concern," the wording represented a sharp upgrade in angst about economic growth, compared with previous statements. The Fed appeared to leave the door ajar for a possible rate cut later this year, if the economy deteriorates further.

Optimally, the Fed's two-track efforts will at least lay the groundwork for both an economic recovery and stronger financial markets. And if policymakers' choices between moral hazard and tough love don't backfire, they will purge the system of weak financial players and promote a more realistic pricing of risk across all markets. Right now, though, that's a very big if.

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