Long-Term Capital Management should have been allowed to fail without government involvement
Tyler Cowen's New York Times column takes us back to an episode that now seems small and insignificant -- the bailout of Long-Term Capital Management in 1998. While LTCM's equity holders were essentially wiped out, regulators stepped in to protect the fund's creditors, primarily Wall Street investment banks that had lent money recklessly to LTCM and allowed it to operate at huge leverage ratios (as high as 100 to 1)..
It is quite clear now that LTCM should have been allowed to fail, for a number of reasons:
First, regulators would have sent a strong message to Wall Street investment banks that they needed to manage their risk exposures more carefully because they would be responsible for their own mistakes. The lack of a bailout would have resulted in billions of losses for Wall Street banks, but they were strong enough in 1998 to absorb the losses and move on with a black eye and an important lesson. Instead, they learned quite a different, perverse lesson.
Second, the lack of an LTCM bailout would have provided regulators with a real-life experiment, showing them how the failure of a large market player could reverberate through the markets. While this would have been a slightly scary exercise, it is highly unlikely that a straightforward bankruptcy of LTCM would have had anywhere close to the impact on the financial system that the most recent crisis has had. Regulators could have learned from an LTCM bankruptcy and improved their economic tool set. Instead, they walked away with the impression that bailouts could avert any doomsday scenario. That impression has now been shattered.
Finally, LTCM should have been allowed to fail without government involvement because it would have been the right thing to do. We argued in a previous post that capitalism is good at dealing with individual failures, and that government should let those happen. Had LTCM not been bailed out, we may never have crossed the threshold at which excesses became so widespread that they became a systemic problem.