The Wall Street Journal
SEPTEMBER 16, 2008

Surviving the Panic

We're happy to report that the world didn't end yesterday, though sometimes it was hard to tell. A major Wall Street banking house filed for bankruptcy, the taxpayers didn't come to the rescue, and financial markets lurched but didn't crash. Amid the current panic, this is a salutary lesson that our fate is in our own hands and that a deeper downturn is far from inevitable.

The immediate priority is to calm markets and prevent a crash, and to do so it helps to recall how we got here. We are not living through some "crisis of capitalism," unless policy blunders make it so. Nor is this largely the fault of the Bush Administration, as Barack Obama claims, or of some lack of regulation, as John McCain asserts. These politically convenient riffs do nothing to reassure the public.

The current panic is the ugly aftermath of the credit mania that took flight in the middle years of this decade. As students of economic historian Charles Kindleberger know ("Panics, Manias, and Crashes"), financial manias throughout history have shared one trait: the excessive expansion of credit. This bubble was no different.

The Federal Reserve kept interest rates too low for too long, creating a subsidy for debt and a global commodity price spike. The excess liquidity and capital flows this spurred became the fuel for the wizards on Wall Street and in mortgage-finance who created new financial instruments that in turn fueled the housing bubble. As long as it lasted, nearly everyone inhaled the euphoria of rising asset prices and soaring profits. Normal risk assessment gave way to the excesses that always attend manias.

Enter the panic stage, or the great deleveraging that began some 13 months ago. Fear now trumps greed, while the short-seller and cash are kings. The core of our financial problem, as Treasury Secretary Hank Paulson said yesterday, is that these mortgage instruments are underpinned by real-estate assets whose value keeps declining. Until home prices stabilize, no one knows how large the losses will be. Thus no one is sure which financial companies are truly endangered, or how many.

Amid this turmoil and uncertainty, the challenge for policy makers is twofold: Protect the overall financial system from the fallout of individual bank failures, and protect the larger economy from recession caused by financial distress. They each require different policy levers.

On the finance side, there has already been much progress, albeit not enough. The banking system is reforming itself right before our eyes, without the advice of Congress or new regulation. The days of banks running with leverage at 30 or 40 to 1 are over. The companies that took those risks have either failed (Bear Stearns, Lehman) or been absorbed by others (Merrill Lynch, Countrywide). The SIVs, CDOs and other exotic creatures have been put back on balance sheets, losses have been taken, and new capital has been raised to absorb those losses. We are moving to a sturdier system.

On that score, Lehman's bankruptcy filing is another sign of progress. The Treasury and Fed have signaled they can say no. While Lehman's failure has spooked markets, the lesson that a storied investment house can fail without a federal rescue is its own crash course in risk management. The weekend decision by a group of major banks to establish a common fund to borrow against is also hopeful. The banks, which each anted up $7 billion to be part of this private lending fund, realize that acting in concert can serve their self-interest -- a lesson that J.P. Morgan would have applauded in the Panic of 1907.

Paul Volcker

And yet the financial system will remain fragile as long as asset values keep declining. More major bank failures are a certainty, including some very large ones. That means more Sunday soap operas like this month's, with all of the anxiety that inspires among the public. The longer these melodramas continue, the greater the risk of a recession.

Which leads us to suggest another Resolution Trust Corp. as one more tool to calm financial markets. The first RTC helped to buy, stabilize and liquidate troubled assets amid the savings and loan mess of the late 1980s. Then it blessedly went out of business. Former Fed Chairman Paul Volcker endorsed an RTC II yesterday in a speech in Naples, Florida, and we suspect the idea will gain more traction. He said he "reluctantly" embraced the idea for "dealing with the market breakdown, breaking the logjam of mortgages and other assets of uncertain value [and] restoring a sense of reasonable valuation and market confidence."

Yes, this would require a Congressional appropriation, and in that sense it would cost taxpayers. But by now it should be clear that some taxpayer money is going to be needed, if only to pay off insured depositors at failing banks. The Federal Deposit Insurance Corp. has already said it may need to borrow from its Treasury line of credit, and that's based on what could be optimistic estimates about home prices.

The taxpayer is also currently at risk through the Fed, which has become ever more creative with its use of the discount window. Its new lending facilities have been necessary amid this crisis, but they have also meant that the Fed is accepting ever-dodgier paper as collateral. Over the weekend it agreed to take non-investment grade paper. The danger is that all of this will put the Fed's own balance sheet at risk -- which would mean even bigger trouble. Better to put this bad mortgage paper on the Treasury side of the federal balance sheet.

Meanwhile, a new RTC would provide a buyer for securities for which there is no market, set a floor under the market, hold the securities until markets stabilize, and liquidate them in an orderly fashion, perhaps at a profit. Failed institutions and managers would not be bailed out. There's always a risk that the politicians will meddle, which is one reason for the Bush Administration to do this now so it can insist on enough political insulation.

As for the larger economy, the last 13 months are a guide to what not to do. The Fed recklessly cut interest rates, while Congress and the White House dropped "rebate" checks from helicopters. The rate cuts ignited another oil and commodity spike that walloped middle-class consumers, while the rebates did nothing to change incentives or lift investment.

We hope the Fed heeds this lesson and holds firm on rates today. Yesterday it injected $70 billion in liquidity to stabilize the fed fund rate at its peg of 2%, as it should in a crisis. But that money can be withdrawn over time as the crisis eases. Meanwhile, a more cautious monetary policy overall will help the dollar, which in turn will mean lower oil prices and more capital flows to the U.S.

What the economy really needs is a big pro-growth tax cut, the kind that will restore confidence and risk-taking. This is an opportunity for both candidates, but especially for Mr. McCain. Instead of focusing on an extension of the Bush tax cuts, the Arizonan should offer his own tax cut to revive capital markets and prevent a recession. Democrats will claim he's helping "the rich," but our guess is that every American who owns a 401(k) will figure he's one of those "rich."

One great lesson of past panics is that they needn't become crashes, if policy makers make the right decisions. Thirteen months into this crisis, the best choices are the same as they were last August: energetic emergency plumbing to protect the financial system, steady monetary policy to defend the dollar, and a tax cut to spur growth. It's also the kind of agenda -- and leadership -- that could win an election.