When a Bailout Works

Many critics worry that the Federal Reserve Board's rescue of Bear Stearns will encourage financial companies to engage in even riskier behavior in the future, on the assumption that the central bank stands ready to bail them out. Economists use the term "moral hazard" -- the lack of an incentive to guard against a risk when you are protected from damaging consequences -- to describe behavior that might be encouraged by policies designed to prevent losses.

But if the Fed takes appropriate precautions, this kind of behavior should not occur. There have been many instances, going all the way back to the Great Depression, in which the government instituted new policies that risked moral hazard. Yet every one of the government's actions resulted in a more stable economic system.

Yellow-metal debate. The first major policy change to draw criticism was the abandonment of the gold standard -- the ability to convert dollars into gold -- in the 1930s. Economists had contended that the gold standard was too restrictive when a financial crisis hit because it prevented central banks from increasing reserves when markets cried for liquidity. But critics argued that without the discipline of gold, governments would print money to satisfy political constituencies and thereby debase their currencies.

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This did not happen. Granted, the paper-money standard we are on now has brought some inflation, but only a few developing countries have debased their currencies. In fact, over the past decade, the worldwide inflation rate was at the lowest level it has been for the past 40 years.

Another groundbreaking policy was the establishment of deposit insurance in 1933. Many feared at the time that deposit insurance would encourage reckless lending by banks, which would no longer feel responsible for keeping depositors' money safe. But instituting deposit insurance quieted depositors' fear of losing money, stopped runs on banks and is now called a great success by economists and policymakers alike. To qualify for insurance, banks must supply sufficient risk capital to avoid moral hazard.

Profit motive. Bear Stearns had adequate risk capital until the very end. In January 2007, its stock traded for $172 and carried a market capitalization of about $20 billion. Management had a large equity stake in the company. Bear's man-agers made risky investments in mortgage-backed securities not because they expected the Fed to bail them out, but because they thought they could earn big profits on them.

At $10 a share, the price JPMorgan Chase is paying to buy Bear, stockholders suffered catastrophic losses -- nearly 95% of their investment in a little more than 12 months. The Fed didn't bail out Bear Stearns stockholders; it bailed out creditors, who had loaned the 85-year-old firm billions of dollars because of the company's reputation as well as against the collateralized value of the securities in which Bear had invested.

The Fed's dramatic rescue of Bear Stearns was appropriate in light of the escalating crisis. However, the Fed's action could also discourage executives of other investment houses from putting more equity into their firms and encourage them to rely more on debt, hoping that the Fed will bail them out, too, in a crunch. If the Fed is going to provide a safety net for nonbank financial institutions, it must mandate that they, like bankers, also provide sufficient risk capital.

Policymakers have successfully navigated moral hazard in the past, and there is no reason that they cannot do so in the future. Let the Fed give more firms access to liquidity, but require them to supply enough equity so that the stockholders, and not the taxpayers, feel real pain if risky bets go bad.

Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.