Hank Paulson, the former Treasury Secretary who helped engineer the roughly $700 billion Troubled Asset Relief Program (TARP) bailout of the financial industry, appeared on CNBC to congratulate himself and others for saving the financial system. He described the crisis as "a 100-year storm." What he fails to note is that the storm was largely self-made by the people that he credited for saving the system.
While Lehman Brothers' bankruptcy is largely seen as triggering the financial crisis, the magnitude of the crisis was entirely the fault of the government. The unpredictable response of the government injected uncertainty into the financial markets sent the crisis into overdrive.
The government is suppose to be a referee, an independent hand to ensure that the rules of the game are fair and obeyed. The markets provide a natural order just like nature. In general the markets distribute the highest return to those to take on the greatest risk. Someone who holds equity gets the biggest return because they can lose everything. Someone who holds debt gets paid less because they have less at risk.
The government stopped playing an impartial role in March of 2008. It intervened on behalf of Bear Stearns shareholders. A week before the Lehman bankruptcy, the government provided $200-400 billion to guarantee the bond holders of Freddie and Fannie that they would be repaid in full. Days before after the Lehman bankruptcy, the government provided $182 billion of support to AIG to ensure everyone who played in the derivative market was made whole.
By October of 2008, the government was not only in the game but was picking the winners and losers of the game on unpredictable terms. Capital structure, the market version of the food chain, meant nothing to the government's decisions. The counter-parties of AIG, who are glorified casino patrons, received every penny of their 'investment' because of the government support, whereas the bond-holders of Lehman received no help.
The government also picked the loser, Lehman Brothers. Beyond the employees of Lehman Brothers, anyone who had lent Lehman Brothers money was a loser. Any person who held Lehman Brothers' debt as collateral was a loser. Anyone who had put collateral with Lehman was at risk. No one could assess the size of the risk, nor how the government would pick winners and losers in the future.
Risk is to capitalism what Kryptonite is to Superman. The government maximized the risk, and then acts surprised when a credit crisis emerges. The market has only one response to the situation created by the government: horde cash. The Federal Reserve and Treasury actions fostered uncertainty and risk. Now they want to praise themselves for saving us from a storm that they largely created.
The experts blame Lehman Brothers, but the financial crisis was largely unavoidable. If the government had saved Lehman, then Merrill Lynch would have been the trigger. Wachovia, Wamu, and others were waiting to trigger the crisis. It was going to happen. The magnitude of the crisis, on the other hand, was the fault of the government. The government started by saving the equity players. Then it was going to save the debt holders. Then it saved no one.
There are people who say that what the government did was better than doing nothing. It is true, but narrowly. This is a little like finishing 10th out of 11th. Yes, you beat the 11th runner, but this success isn't something for which to appear on TV five years after the fact talking about it as though it was an accomplishment.