Light at the End of the Tunnel?

| Thu Sep. 18, 2008 12:27 AM EDT

LIGHT AT THE END OF THE TUNNEL?....Oddly enough, this Wall Street Journal piece about the credit crisis may be good news:

Lingering hopes that the damage could be contained to a handful of financial institutions that made bad bets on mortgages have evaporated. New fault lines are emerging beyond the original problem — troubled subprime mortgages — in areas like credit-default swaps....Expectations for a quick end to the crisis are fading fast....[etc. etc.]

I'll probably regret writing something so glib, but bankers are panickers. They panic when markets are going up and they panic when they're going down. One of the signs that you're near the top of a bubble is when the panic grows so deep that everyone convinces themselves that the laws of economics have changed forever and there's really no bubble at all. Likewise, one of the signs that you're approaching the nadir is when the panic grows so deep that everyone convinces themselves that there's no end in sight. So maybe we're close to the bottom.

Not that we're all the way there yet, by any stretch. We've still got a pretty tough recession ahead of us as we start to wind down our gargantuan current account deficit. Still, it's possible that once WaMu's hash gets settled, the worst of the panic might start to subside, and then we'll face only a painful but basically orderly retreat for another year or two before bouncing back. We can hope, anyway.

This, by the way, is why I think the feds might end up making a profit on AIG. Once the worst of the panic subsides, it's likely that AIG's losses are going to turn out to be huge but not completely catastrophic. Nobody knows what all their bundled up assets are worth, but eventually they'll get unwound and I suspect they'll turn out to be worth more than the dime-on-the-dollar that everyone is currently valuing them at. When that happens, Uncle Sugar will cash in its warrants and come out ahead on the deal.

So does that mean I approve of the AIG bailout? You bet. For two reasons. First, Paulson and Bernanke seem like pretty decent technocrats to me, and they have way more information about what's going on than any of the rest of us. I suspect they wouldn't have agreed to the bailout unless a genuine meltdown was really the alternative. Second, I'm not very worried about moral hazard. It's way overrated as a genuine motivation for human activity. (Nobody wants to run their company into the ground, bailout or not. Even in the healthcare market, where moral hazard is a far more concrete issue, it appears to have only a modest effect on actual behavior.) Besides, I think the government should backstop the financial markets — as long as those markets are properly regulated up front. In the modern world, no one else can do it. So I say: go ahead and bail out AIG, but then implement a new regulatory regime that covers all financial activity, not just the small part of the market that it covers now. Voilà. Moral hazard problem solved.

As for the scope of that regulation, it's not so much that it has to be a lot stricter (though there may be some of that), but that it needs to be broader. You have to regulate the money flows wherever they happen to be. If the derivatives market is where the big money is, then that's what you regulate. If it's hedge funds, you regulate those. If it's big enough to cause a problem, you regulate it. You can't do it with the same tools that you'd use to regulate, say, deposit accounts, but you can still use a lot of the same principles — even if the eventual implementation ends up being orders of magnitude more complex.

And as long as you don't overdo it, the end result is smoother and more profitable capital markets. Regulation is a way of reducing panic when markets are rising, and government backstops are a way of reducing it when they're falling. They are the yin and yang of modern finance. With any luck, the events of the past year have finally persuaded even Republicans of this.