"let the hedge fund Long-Term Capital Management fail in 1998—preferably in a messy and disorderly fashion—we'd be much better off today"

Justin Fox on the Curious Capitalist:

"Tyler Cowen makes the case in Sunday's New York Times( I POSTED ABOUT THIS ) that if the Federal Reserve had just let the hedge fund Long-Term Capital Management fail in 1998—preferably in a messy and disorderly fashion—we'd be much better off today( MAYBE ):

With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed.

Sure, he goes on, a "rapid financial deleveraging" might have followed in the wake of an LTCM failure, probably plunging the economy into recession. But that wouldn't have been all bad:

In 1998, there was no collapsed housing bubble, the government's budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.

Cowen is saying that occasional financial crises are healthy, even if they lead to recessions, because they teach market participants to take risk seriously. By averting crises and recessions so successfully over the past quarter century, the Fed thus laid the groundwork for the current megacrisis. ( I DON'T AGREE HERE )

It's an argument that makes a lot of intuitive sense, and appeals to practical students of the market—like Barry Ritholtz, who devoted a long, approving post Sunday to Cowen's article. It also shares much with the no-pain, no-gain Austrian theories of the business cycle that Cowen, while not a true believer, treats with far more respect than most academic economists do( I DON'T BELIEVE THIS ).

More typical is Paul Krugman, who once charmingly described Austrian business cycle theory as being "about as worthy of serious study as the phlogiston theory of fire." Krugman was back on the topic Saturday with a blog post tearing into the idea that a downturn could ever be healthy( I AGREE THAT THEY'RE NOT HEALTHY. I'M JUST NOT SURE THAT WE CAN PREVENT THEM ).

I've written about this debate before, in particular the fact that European economists don't seem so deathly afraid of recessions as their American counterparts. I've never really picked a side, though, and I still can't. It seems clear to me that smallish financial crises and concomitant recessions might actually be healthy, or at least necessary evils( HERE I AGREE ). But it seems even clearer that really big financial crises cause so much collateral damage as to swamp any salutary effects. And it's really hard for Fed policymakers to know ahead of time which sort of crisis they are facing( TRUE ).

For a little while, the late summer and early autumn of 1998 felt like the end of the financial world. In retrospect, it looks like it would have been a much better time for a full-on financial panic than 2007-2008 has turned out to be. That doesn't provide a very useful guidepost, though, for economic decisionmakers who don't possess the gift of clairvoyance."( THAT'S A FAIR POINT ).

I believe that LTCM should have been saved by being taken over by the government and then privatized, after which some form of Bagehot's Principles should have been implemented. In fairness to the Fed, I believe that most investors wanted LTCM saved, and expected it to be saved. That's what the government is there for, in their view.

The only change in the current situation has not been in the government responding, which markets and investors were counting on, but in the magnitude of the crisis and the ineffectiveness of the government's response. I would say that what the markets and investors had was complacency, based upon their belief that the S & L Crisis, LTCM, and other financial problems had eventually been effectively dealt with in recent history. The shattering of that complacency is a major contributor to the fear and aversion to risk and the accompanying flight to safety.