Don't Panic!

Thinking of the collapse of Lehman Brothers on Monday, we are reminded of the immortal words on the cover of the Hitchhiker's Guide To The Galaxy, Don't Panic! For one thing, the fact that Lehman was allowed to fail was both predicted, and predictable.

Writing after the U.S. government effectively bailed out Bear Sterns in March, facilitating its takeover by J.P. Morgan, economic analyst Jim Manzi said: "Bear is the counterparty to many credit contracts (hence its problems). The risk of letting such an institution fail is that otherwise healthy institutions go down with it.

"Because of the central role of leverage in the financial sector, and the central role of the financial sector in funding every other sector of the economy, this would be a disaster.

"Of course, it creates a moral hazard, but on balance is almost certainly worth doing.

"That said, my guess is that we're likely to see some other household name that is not too big to fail go down before this is all over - the government will need to demonstrate that it is willing to do this.

"Not for nothing, but I wouldn't be investing a lot of my retirement account with Lehman right now."

John Berlau, of the Center for Entrepreneurship at the CEI, said after Lehman was allowed to collapse: "My reaction to Lehman Brothers' declaring of Chapter 11 bankruptcy and the refusal of Treasury Secretary Hank Paulson and others to take extraordinary Bear Stearns-like measures for the government to prop the firm up can be summed up in three words: It's about time!

"Business failure is not only a permissible outcome of capitalism, it's a necessary one. As the great economist Joseph Schumpeter has written, the process of "creative destruction" is essential for the market to function. For innovation to flourish and the standard of living of the populace to improve, the market must be free to reward success and punish failure."

The current penchant of the government to intervene with taxpayers' money, most recently to take control of mortgage giants Fannie Mae and Freddy Mac is a worrying trend, replicated around the world of governments interfering in the free market.

The problem that they face when making these decisions of course, is as Manzi wrote, the interconnection of the financial industry and the rest of the economy - a problem made worse when the government was persuaded to overturn the Glass-Steagall Act which prevented the merging of inventment and commercial banks.

By removing this protection, the government allowed the rise of the mega-banks where cash-rich commercial banks merged with investment banks and other financial institutions, then started underwriting and trading instruments such as mortgage-backed securities and collateralized debt obligations, activity that, it has been suggested led to the current sub-prime mortgage 'crisis'.

That's the environment in which we find ourselves though and there's no point 'crying over spilled milk' and certainly no reason for further legislative interference in the make-up of the markets.

In fact, it can be argued that governments messing with the financial markets often causes the very problems they say they're trying to avoid. For example, Fannie and Freddie were for years operating as if they were government-run and followed the agenda of the ruling political parties. Look where that's got us.

By intervening in the markets and bailing out companies with taxpayer money, the effect on the economy, now deprived of money that could be better spent elsewhere, or given back to the taxpayer, is immeasurable, affecting sectors of the economy and people who would have otherwise been unaffected.

It's time for the madness to stop. Let the markets work as they're supposed to and, most importantly, don't panic!