Killing the Bear

The blogosphere is filled with noise, largely complaints about the bailout of Bear Stearns. The left calls it corporate welfare, the right calls it moral hazard. But to me, it sure doesn’t look like much of a bailout. It’s more like a mercy killing.

Why would the Fed engineer such a thing? It all has to do with counterparty risk. Technically, it’s quite complex, but think of it as a bunch of mountain climbers roped together. The rope mitigates risk; should one climber lose his grip and fall, the rest will hold him up. But The Bear is like a sumo wrestler climbing the mountain: if The Bear falls, a lot of others would go with it. And the others are tied to still others, and they would fall too. It is easy to imagine a cascade of collapsing financial institutions.

Of course, when financial institutions fail, their customers often fail was well. Many businesses run on credit and, lacking credit, they might have to shutter their factories, warehouses, and stores. This could lead to something like the Great Depression – or even worse.

Fortunately, Bernanke is a great student of the Depression, and he’s doing his best. Unfortunately, the wrong actions by politicians could overwhelm whatever actions the Fed can take. And two Presidential candidates are already promising to do so. This could get very very ugly.

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