Pledges and further action from the Fed and the Treasury earlier in the week were clearly designed to avert a total bloodbath in the mortgage business but, as institutions steadily yield more power and influence on market dynamics, two questions come to mind.
1. At what point does interference begin to stifle development, or put another way, at what point does the marginal benefit of regulation begin to be outweighed by the marginal cost of such regulation?
2. At what point does bailing out institutions that are effectively considered bankrupt lead to a significant increase in moral hazard (which just sows the seeds of future bubbles)?
Answering either question with any degree of precision is clearly a futile exercise. Greater regulation and greater intervention are both to some extent actions that counter the very principles of capitalism. By regulating markets, for example, we take away a certain degree of flexibility which can have an adverse effect on economic development. Certainly markets are smart and creative enough to find ways around such regulations (part of the reason why we find ourselves in the current mess is a result of shadow banking activities caused by regulation).
And what about the issue of bailing out businesses that, in normal circumstances, would go bankrupt? We are just emerging from an era in which access to capital was both cheap and very easily obtainable. That environment led to a lot of businesses that would normally go bankrupt to stay afloat. Now that rates are rising, a wave of bankruptcies are exacerbating an already difficult environment. We can draw similarities with the Fed's intervention to avert bankruptcies, but the objective is very different. In the Fed's case, the reason for bailing out is to avert systemic risk from taking hold. But doing so introduces another dilemma, the so called moral hazard put option.
In the end, it is a delicate balancing act the final outcome of which only the passage of time will tell...
