Not long ago, as this financial crisis continued to worsen, I criticised the Fed at one point for seeming to panic (when it cut interest rates further and faster than expected) and the Treasury for attempting to delay the inevitable (over Fannie Mae and Freddie Mac). Today I owe both of them a commendation for acting prudently and decisively.
In an astonishing sequence of events, the government has nationalised Fannie and Freddie; has let Lehman go to the wall; showed it was willing to see Merrill Lynch go the same way; has all but nationalised AIG; and has held firm, for the moment, on interest rates. Without knowing what the Fed and the Treasury knew--especially about the systemic consequences of an AIG bankruptcy--it is impossible for an outsider to be sure, but all of these, I think, were good calls.
The bravest thing was to stand aside and watch Lehman crash. This was necessary not so much to draw a line in the sand, as some analysts put it--after all, one day later, the AIG intervention stepped over that line--but to affirm in the starkest possible way the government's reluctance to put taxpayers' funds at risk. Because of Lehman, and AIG notwithstanding, the Treasury and the Fed can credibly say that shocking financial collapses will be allowed to happen so long as the systemic consequences can be contained. If there is to be any hope even of mitigating the moral hazard unleashed by the current phase of unavoidable crisis management, this was a crucial message to send.
Denying Wall Street an immediate further cut in interest rates was brave too; and this also made sense. Before much longer, the Fed might be glad that it conserved a while longer what little powder remains in its arsenal.
We will see what the markets make of the AIG intervention in due course--but the immediate verdict on Lehman and interest rates was encouraging. Monday's fall in share prices was bad but by no means terrifying, and the market rallied the next day. The dismantling of Lehman's business had not caused instant paralysis, and was proceeding in orderly fashion. The authorities were surely braced for a far worse response, and are bound to think that they got off lightly.
All this, and a presidential election too. The bewildered candidates are doing what they must: trying to give the impression that they understand what is going on (something that eludes the people in the middle of it all) while mocking the proposals of the other side (which in practical terms are indistinguishable from their own). John McCain is so far seen as the loser in this, partly because his statement that the economy is "fundamentally strong" is seen as a gaffe, and partly because Barack Obama is a little more trusted by voters on economic issues. Bad economic news is thought to be to the Democrat's advantage.
I doubt this should be taken for granted, and not just because Mr Obama's lead on economic competence has diminished, oddly enough, of late. Attacking Mr McCain's comparative optimism should not be taken too far: voters look to a leader for reassurance. Also, there is a germ of truth in the claim that the economy is fundamentally strong: who would have believed that the past year's financial stresses could have failed, as yet, to drive the economy deep into recession? In its own way, this is remarkable.
When it comes to short-term remedies, I see little or no disagreement between the campaigns. Neither has attempted to second-guess this week's initiatives. The Obama campaign is leaning heavily, and with much justification, on blaming the Bush administration for what has happened. But Mr McCain's new "change Washington" strategy may have put enough distance between him and the White House to blunt this attack.
So far as the future is concerned, both campaigns agree that financial regulation will need to be tightened up. And whoever is president will confront a fiscal outlook (an undeniable legacy of the Bush administration's incontinence) that is quickly going from bad to much, much worse. Neither campaign has come close to acknowledging the limits to the government's ability to socialise the losses of its crippled new acquisitions while simultaneously priming the Keynesian pump with tax cuts and enormous new programs of public works--all from a base of chronic fiscal indiscipline. If you were wondering what turn the crisis might take next, that would be one place to look.
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