The Atlantic | October 2002

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Contents | October 2002

More on politics and society from The Atlantic Monthly.

The Atlantic Monthly | October 2002

[From "The Roaring Nineties," by Joseph Stiglitz]

Moral Hazard

Alan Greenspan freely admitted that by orchestrating a rescue of Long-Term [Capital Management], the Fed had encouraged future risk takers and perhaps increased the odds of a future disaster. "To be sure, some moral hazard, however slight, may have been created by the Federal Reserve's involvement," the Fed chief declared. However, he judged that such negatives were outweighed by the risk of "serious distortions to market prices had Long-Term been pushed suddenly into bankruptcy."

If one looks at the Long-Term episode in isolation, one would tend to agree that the Fed was right to intervene, just as, if confronted with a suddenly mentally unstable patient, most doctors would willingly prescribe a tranquilizer. The risks of a breakdown are immediate; those of addiction are long term. But the Long-Term Capital case must be seen for what it is: not an isolated instance but the latest in a series in which an agency of the government (or the IMF) has come to the rescue of private speculators. In one decade, this unfortunate roster has grown to include the savings and loans, big commercial banks that had overlent to real estate, investors in Mexico, Thailand, South Korea, and Russia ... and now various parties affiliated with Long-Term Capital ...

Permitting such losses to occur is what deters most other people and institutions from taking imprudent risks. Now especially, after a decade of prosperity and buoyant financial markets, a reminder that foolishness carries a price would be no bad thing. Will investors in the next problem-child-to-be, having been lulled by the soft landing engineered for Long-Term, be counting on the Fed, too?

— From When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein (2000)

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