Treasury Continues to Fumble -- Will They Ever Get it Right?

By Dean Baker, Comment Is Free. Posted March 18, 2009.

There are few economists who would defend the decision to allow Lehman Brothers to go bankrupt last September. Its collapse induced a worldwide panic that sent stock markets plummeting and caused credit to freeze up. In the subsequent months, the downturn went into over-drive, with the United States losing almost three million jobs from October through February.

This set of events has led almost everyone to conclude that the trio who let Lehman go under -- Treasury secretary Henry Paulson, Federal Reserve chairman Ben Bernanke and the then-head of the New York Fed, Timothy Geithner -- erred badly in this decision. That seems a reasonable judgment.

However, the conventional wisdom includes a corollary that is much less obvious: because the Lehman bankruptcy was a disaster, U.S. taxpayers must honor in full all the debts of all the banks. This corollary could put U.S. taxpayers on the hook for trillions of dollars in commitments that the Wall Street boys apparently made on our behalf. Before we cough up the dough, we might want to consider whether Paulson, Bernanke and Geithner were not quite as stupid as the current conventional wisdom would imply.

The problems that followed from Lehman did not just stem from the fact that the government was not honoring Lehman's debts. This was an uncontrolled bankruptcy of a huge investment bank in a world where the official line was still that everything was under control. The Washington Post had even run a column the day before Lehman's collapse ridiculing those who were making negative comments about the state of the economy.

In this context, an uncontrolled bankruptcy of a major investment bank was sort of like a sledge hammer in the face: a rather rude and unexpected blow. The most immediate consequence was that Reserve Primary, one of the largest money-market mutual funds in the world, suddenly could not pay its shareholders in full, because it had tens of billions invested in Lehman. In the wake of Lehman's bankruptcy, Reserve Primary did not know how much, if any, of this investment it could recover. In the post-Lehman world banks could suddenly no longer trust each other, and the interbank lending rate went through the roof.

But now we have had six months to adjust. The Fed and Treasury are now guaranteeing deposits in money-market mutual funds. The Federal Deposit Insurance Corporation doubled the size of the bank accounts it guarantees, and non-interest-bearing accounts of any size are guaranteed. In addition, the Fed is now lending hundreds of billions of dollars directly to non-financial corporations, establishing a channel of funding that goes outside the banking system.

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Dean Baker is co-director of the Center for Economic and Policy Research.

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