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Moral hazard in the policy response to the 2008 financial market meltdown.

Article Excerpt
The Cato Institute is the ideal place to draw lessons from the subprime crisis. The organization's mission focuses on the interaction of public policies with free markets and limited government. Even the most ardent believer in free markets must fully understand that individual liberty implies neither the nonexistence nor the indifference of government to economic affairs. Individuals live in freedom and peace when public policies are crafted in accordance with well-established rules and implemented with an eye toward effectiveness, not expansion. In the halls of government, we need sobriety and vigilance rather than apathy or empire building.

The playing out of the subprime crisis has revealed a weakness in our public policy framework for dealing with institutional failure in financial markets that invites a continued expansion of government into areas that should be the domain of private citizens and institutions. In particular, policymakers have been unwilling to let financial institutions that made unwise decisions bear fully the negative consequences of those decisions. Procedures exist to provide liquidity to solvent but illiquid institutions, and other procedures exist to liquidate insolvent institutions. But as the subprime crisis emerged, the government failed to adhere to a consistent policy for dealing with troubled institutions, opening itself up to special pleading from many of these institutions at unnecessary cost to the taxpayer.

The Subprime Crisis in Brief

The most important lessons for monetary policy that we draw from the subprime crisis do not pertain to its formation. With regard to the path we took to get here, the players have changed but the game remains the same. The raw material for the subprime crisis is really no different than for other financial crises we have seen in the past. Financial crises occur when financial innovation meets excessive optimism. It is an insight that can be attributed to the late economist John Kenneth Galbraith in A Short History of Financial Euphoria that all financial innovation is simply another way to issue debt--specifically, a way to issue debt against the value of an asset that previously was not available to be leveraged. Securitized pools of subprime mortgages are the best, but certainly not the only, example of this financial innovation in the current crisis.

That there has been excessive optimism about asset prices in recent years is not really a matter of dispute. In fact, the formation of both the Internet bubble and the housing bubble were diagnosed in real time. The prevailing response was to find excuse after excuse to look the other way. Robert Shiller's wonderful recap of recent bubbles, Irrational Exuberance, takes its title from a remark by Alan Greenspan who as Federal Reserve chairman, saw the Internet bubble forming but was unwilling to use monetary policy to let the air out of it. As the Federal Reserve lowered interest rates dramatically to deal with the aftermath of the bursting of the Internet bubble, it sowed the seeds of the housing bubble, as cheap credit and new financial products enabled financial institutions to extend mortgage finance to ever riskier borrowers. This by itself would not have been enough to create the current environment....