Thank you, Claire, for the invitation, and thank you, Emily, John, Michael, Bob, and others for the comments.
Claire, you zoomed right in on the point of the book: what is the government's role in markets? How and when should it play that role? Where does the "market" end and government begin?
I'll answer your practical point. What would have happened had Washington allowed free markets to sort out the mess starting with Lehman's collapse on 9/14/08 (my wedding day, too, btw) without extraordinary government action?
Like you, I don't know what would have happened. Here is what I think.
Had the government not stepped in with TARP and other measures, the markets would have determined that the financial industry's business model of a quarter century was a catastrophic failure.
That business model was:
- a) to assume that all risk could be quantified and quarantined, thus eliminating the need for self-control when it came to borrowing against risk, and
- b) to assume that when business model a) failed, the government would step in with extraordinary aid. The government had taught financial firms, in precedent after precedent, to expect bailouts in a crisis. This expectation was built into the financial system.
In punishing failure, then, markets would have let failed banks and other financial companies die in September 2008. Those institutional deaths would have included AIG, Goldman Sachs (which would have failed in thinking that the government would bail it out of its contracts with AIG), Citigroup, Bank of America, Merrill Lynch, GE Capital (and possibly GE itself; I'm not sure how the corporate structure works there), JPMorgan Chase (whose mistake would have been to exist at all in an irrational market environment), and others. No financial institution can survive the evaporation of its overnight financing.
With financing gone, industrial companies and small businesses would have had to slash their payrolls and their orders to an even greater extent than they did. We would have more strain on the social safety net, more people out of work for months or years on end, their skills and psychological states decaying, and, in the end, an even bigger and more protracted federal stimulus to combat unacceptable social pain.
I could be wrong about this alternate reality. Maybe hours after our largest banks had failed, entrepreneurs would have created new banks, with regulators fast-tracking the process. Maybe all of the money searching for a safe haven would have gone to those new banks. I doubt it, though. Adjustment works, and is vital to free markets, but it doesn't work that quickly. One bank can fail; they all can't.
In the end, politicians who couldn't know the future determined that the risk of one unknown was just too great.
Would my scenario have been better or worse than what has actually happened? More than a year and a half after having written the book, I think it is too early to tell.
The 2008 bailouts were the right thing to do if Washington -- really, the electorate -- learns the right lesson. Government must enforce limited, predictable rules that help markets discipline themselves all the time, rather than wait until a crisis comes and offer unlimited and arbitrary support. We've got to have a way in which financial companies can fail without taking down the rest of the economy. If market participants know that won't happen, they know, too, that firms can't fail. (More on how to do this later).
The wrong lesson to learn, on the other hand, is that bailouts work. That's the lesson that the academic and technocratic class seems to have absorbed. If so, all we've bought is years of stagnation in which only implicitly guaranteed financial firms thrive. Eventually, financial firms will exploit their government support so expertly that they'll create a crisis from which we can't rescue ourselves. To see what happens when your financial industry becomes too big for bailouts, look at Ireland.
It would be better for politics to work before markets do. If Washington doesn't create an environment in which financial firms police themselves, global markets will someday police Washington, demanding (much) higher interest rates on the national debt.
Let me read through the rest of the comments on the earlier thread and respond. I will post an original thread later this evening (EST), too.