Financial Crisis: How to Stop the Panic

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On Oct. 8, U.S. Treasury Secretary Henry Paulson broadly hinted that Washington is likely to use a targeted approach with at least some of the $700 billion authorized by Congress to deal with toxic mortgage-backed securities and other assets—including buying equity shares in some financial institutions.

A targeted approach doesn't waste money on weak banks that deserve to disappear. "You are going to see significant consolidation in banking across Europe. As the tide goes out, the weak models and weak managements are revealed," says Robert E. Diamond Jr., president of Barclays (BCS), the British banking company. More policymakers and economists are coming around to approaches such as Britain's because of the manifest failure of loans, guarantees, and asset purchases to get the job done. In fact, an unhealthy dynamic has developed. The Fed and other central banks have steadily expanded the portions of the economy to which they are lending freely—in effect, declaring them to be protected within the walls of the fortress. But it's having unintended consequences.

Central bankers' desperate extension of credit to new kinds of borrowers simply worsens the condition of solvent institutions left outside the walls, because investors and lenders pull money out of them. That explains the wild swings in stock prices and credit spreads. For example, the branches of British-owned banks in Ireland lost money to locally owned rivals after Dublin offered blanket protection on all deposits of Irish-owned banks there. And in the U.S., corporations that borrow in the commercial paper market were cut off from funding because investors moved to safer Treasuries—forcing the Fed to say on Oct. 7 that it would step in to buy the commercial paper itself. The logical endpoint of this game is for governments to protect all financial assets. That's an awfully Big Government outcome for an approach that started out with a small-government thrust.

Moral Hazard

U.S. policymakers have sometimes departed from the helicopter-money approach, as in the rescues of Fannie Mae (FNM), Freddie Mac (FRE), and American International Group (AIG), which gave the government big equity holdings. They may need to jettison another bit of orthodoxy, which is that it's dangerous to make explicit promises of taxpayer support for fear it will encourage risky behaviors. Economists have long been taught to avoid creating "moral hazard"—giving people an incentive to take big risks. Letting Lehman Brothers fail was intended to send a warning to risk-takers. But by trying so hard to avoid moral hazard, governments aren't giving markets the confidence they need, says Richard Portes, an economist at the London Business School, adding: "In circumstances like this, the last thing you want is ambiguity."

The longer the banks are incapacitated, the worse the damage to the real economy. "Banking institutions are really the rock foundation of all of the economic activity that occurs," says Edward Liebert, who is treasurer of Philadelphia-based chemical maker Rohm & Haas (ROH) as well as chairman of the National Association of Corporate Treasurers. Policymakers are getting the message. "Generally speaking, central banks and governments are just beginning to understand the severity of the crisis and how it impacts on their economies," says Donald Moore, chairman of Morgan Stanley in Europe. "My view is we are going to take another three to six months to sort this." It may take that long for the generals to learn how to fight this war, not the last one.

With Jack Ewing in Frankfurt.
Coy is BusinessWeek's Economics editor. Reed is London bureau chief for BusinessWeek.