Enron was the poster-child of the 1990s boom; the company had trans-
formed itself from the owner of regulated natural gas pipelines into a
financial firm that traded natural gas, petroleum, electricity, and broad-
band width as well as owning water systems and an electrical power
generating system. The top executives of Enron felt the need to show
continued growth in profits to keep the stock price high, and in the late
1990s they began to use off-balance sheet financing vehicles to obtain
the capital to grow the firm; they also put exceptionally high prices on
some of their long trading positions so they could report that their trad-
ing profits were increasing. The collapse of Enron led to the failure of
Arthur Andersen, which previously had been the most highly regarded of
the global accounting firms.
MCIWorldCom was one of the most rapidly growing telecommunica-
tions firms. Again the need to show continued increases in profits led
the managers to claim that several billion dollars of expenses should
be regarded as investments. Jack Grubman had been one of the sages in
Salomon Smith Barney (a unit of the Citibank Group); he was continually
promoting MCIWorldCom stock. Henry Blodgett was a security analyst
for Merrill Lynch who was privately writing scathing e-mails about the
economic prospects of some of the firms that he was otherwise promoting
to investors; Merrill Lynch paid $100 million to move the story off the
front pages. Ten investment banking firms paid $1.4 billion to forestall
trials. The chairman and chief executive officer of the New York Stock
Exchange resigned soon after it became known that he had a compensa-
tion package of more than $150 million; the exchange served both as a
tent for trading stocks and as a regulator and it appeared that the man-
agers of some of the firms that were being regulated served as directors of
the exchange and participated in determining the compensation package.
Then a number of large U.S. mutual funds were revealed to have allowed
firms to trade on stale news.
More individuals have already gone to prison than in the aftermath of
any previous crisis, and a number are still awaiting trial. Six Enron senior
managers already have been jailed. One Arthur Andersen partner who
worked on the Enron account went to prison. Two of the senior financial
officials of MCIWorldCom have gone to jail. Martha Stewart was found
guilty of obstruction of justice and imprisoned for five months.
The subject of Chapters 10 and 11 is crisis management at the domestic
level. The first of these two chapters considers the range of domestic re-
sponses to a crisis; at one extreme the government may take a hands-off
position, at the other there is a range of miscellaneous measures. Those
who believe that the market is rational and can take care of itself pre-
fer the hands-off approach; according to one formulation, it is healthy
for the economy to go through the purgative fires of deflation and
bankruptcy to get rid of the mistakes and excesses of the boom. Among
the miscellaneous devices are holidays, bank holidays, the issuance of
scrip, guarantees of liabilities, issuance of government debt, deposit in-
surance and the formation of special institutions like the Reconstruction
Finance Corporation in the United States (in 1932) or the Istituto per la
Ricostruzione Industriale (IRI) in Italy (in 1933). The Italian literature
calls the process the ‘salvage’ of banks and companies; the British in
1974–1975 referred to saving the fringe banks as a ‘lifeboat’ operation.
The questions related to a domestic lender of last resort are the focus
of Chapter 11—primarily whether there should be a lender of last resort,
who this lender should be and how it should operate. A key topic is
‘moral hazard’—if investors are confident that they will be ‘bailed out’
by a lender of last resort, their self-reliance may be weakened. But on the
other hand, the priority may be to stop the panic, to ‘save the system
today’ despite the adverse effects on the incentives of investors. If there is
a lender of last resort, however, whom should it save? Insiders? Outsiders
and insiders? Only the solvent, if illiquid? But solvency depends on the
extent and duration of the panic. These are political questions, and they
are raised in particular when it becomes necessary to legislate to increase
the capital of the Federal Deposit Insurance Corporation (FDIC) or the
Federal Savings and Loan Insurance Corporation (FSLIC) when one or the
other runs out of funds to lend to banks in trouble in time of acute stress.
The issue was particularly acute in the 1990s in Japan, where the collapse
of the Nikkei stock bubble in 1990 uncovered all sorts of bad real estate
loans by banks, credit unions, and other financial houses, confronting
the government with the neuralgic question of how much of a burden
to put on the taxpayer. Particularly troubling was the catatonic state of
government in Japan in the 1990s, slow to decide how to meet the crisis
and slower to act.
The penultimate chapter centers on the need for an international
lender of last resort to provide global monetary stability even though
there is no responsible government or agency of government with the
de jure responsibility for providing this public good. U.S. government
support for Mexico, first in 1982 and again in 1994 was justified on the
grounds that countries of the North American Free Trade Agreement
(NAFTA) should stick together and that assistance to Mexico would
dampen or neutralize the contagion effect and prevent a collapse of
lending to the ‘emerging market’ countries of Brazil and Argentina and
other developing countries. The sharp depreciation of the Thai baht in
the early summer of 1997 triggered crises in nearby Asian countries in-
cluding Indonesia, Malaysia, and South Korea as well as in Singapore,
Hong Kong, and Taiwan.
The last chapter seeks to answer two questions; the first is why there
has been so much economic turmoil in the international financial econ-
omy in the last thirty years, and the second is whether an international
lender of last resort would have made a difference. The International
Monetary Fund was established in the 1940s to act as an international
lender of last resort and to fill an institutional vacuum; the view was
that financial crises in the 1920s and the 1930s would have been less
severe had there been an international lender of last resort. The large
number of crises in the last thirty years leads to the question of whether
the presence of the IMF as a supplier of national currencies to countries
with financial crises encouraged profligate national financial policies.
Financial arrangements need a lender of last resort to prevent the es-
calation of the panics that are associated with crashes in asset prices. But
the commitment that a lender is needed should be distinguished from
the view that individual borrowers will be ‘bailed out’ if they become
over-extended. For example, uncertainty about whether New York City
would be helped, and by whom, may have proved just right in the long
run, so long as help was finally provided, and so long as there was doubt
right to the end as to whether it would be. This is a neat trick: always
come to the rescue, in order to prevent needless deflation, but always
leave it uncertain whether rescue will arrive in time or at all, so as to in-
still caution in other speculators, banks, cities, or countries. In Voltaire’s
Candide, the head of a general was cut off ‘to encourage the others.’ A
sleight of hand may be necessary to ‘encourage’ the others (without,
of course, cutting off actual heads) to participate in the lender of last
resort activities because the alternative is likely to have very expensive
consequences for the economic system.
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