PAULSON'S MOMENT OF TUTH

THE WASHINGTON POST
By Sebastian Mallaby
September 16, 2008

In taking the top job at Treasury two years ago, Hank Paulson said he wouldn't be content to keep the seat warm. He was running Goldman Sachs, the preeminent investment bank, and he had no need to come to Washington if he wasn't going to make an impact. Until Sunday, it was pretty hard to see where Paulson's impact lay. His environmental interests had not caused a sprouting of green policies. His strong contacts in China had fostered a bilateral talkfest but no tangible breakthroughs. And his efforts to manage the financial crisis had been conventional and tentative until his bold gamble on Lehman Brothers.

President Bush's first Treasury secretary, Paul O'Neill, trumpeted his distaste for bailouts while still bailing out Argentina, Brazil and Turkey. Paulson began in similar vein, declaring his belief in markets while presiding over the March bailout of Bear Stearns, extending credit from the Fed's discount window to all investment banks, and nationalizing Fannie Mae and Freddie Mac, the two monster mortgage-lending companies. Going into the weekend, most people assumed that Paulson would do the same again. But instead he refused to extend taxpayer-backed loans to Lehman, causing prospective buyers of the firm to walk away and forcing Lehman to declare bankruptcy.

After the Bear Stearns bailout, it seemed that a new financial doctrine had been born. It used to be said that a bank was "too big to fail," meaning that its collapse would cause heavy losses at other banks that had lent to it, inflicting unacceptable pain on the economy. Bear's rescue seemed to inaugurate the doctrine of "too entangled to fail," which held that even a small bank could not be allowed to go down if it had enmeshed itself in the vast and opaque swaps markets. The argument was that a collapse of a major swaps player would sink the banks on the other side of those swaps. If, say, Morgan Stanley had controlled its exposure to a falling dollar by selling that risk to Bear, bye-bye to Bear could mean bye-bye to Morgan.

In refusing to bail out Lehman, Paulson put an end to the too-entangled doctrine. He gambled that he could let Lehman fail without sowing market pandemonium, not least because Lehman's demise had been predicted for weeks, allowing players in the swaps market to take steps to protect themselves. As of Monday afternoon, Paulson's bet had generated some scary moments. Stocks fell, and credit markets were naturally repricing the risk of lending to banks. But there was no instant catastrophe.

If Paulson's gamble pays off, it could affect the character of globalization. For the past two decades or so, international finance has developed largely on U.S. terms and in the U.S. image. The Federal Reserve has stood behind the dollar, which is the world's dominant reserve currency, and the world's faith in the dollar has allowed the Fed to cut interest rates in response to global shocks such as Russia's default in 1998 without risking a run on the currency. Meanwhile, U.S. banks have dreamed up funky new financial instruments that have been marketed all over the world. To a considerable extent, the globalization of finance has meant its Americanization.

The first 12 months of this crisis scrambled that equation. The Fed cut interest rates, as it often does in response to trouble. But this time the world lost confidence in the dollar, which failed to play its traditional role as a safe store of value in tough times and instead seesawed wildly. The innovative U.S. banks lost billions of dollars and were forced to turn for help to the new masters of finance -- foreign sovereign wealth funds. And U.S.-style financial innovation suffered a massive reputational blow. No less a commentator than Paul Volcker, the former Fed chairman, has emerged to denounce it.

The longer the financial turbulence goes on, the greater the likely backlash against U.S.-style financial globalization. But Paulson's gamble -- if it succeeds -- could limit the damage. By refusing to use the Fed's balance sheet to bail out Lehman, he may have saved the Fed from becoming further bogged down in its crisis-management role, freeing it to focus more on preserving the value of the dollar. And by repealing the too-entangled doctrine, Paulson may have strengthened market penalties for banks that mismanage modern financial instruments -- thereby increasing the chances that sophisticated, market-based finance can flourish safely.

Shocking though it may sound now, there is much to like in U.S.-style financial globalization. America's critics may be tempted to celebrate the dollar's dethronement, but ordinary savers from Brazil to Belarus are grateful for an international store of value. The critics may say that the newfangled financial instruments are inherently dangerous, but this is only true when they are combined with excessive borrowing. The challenge over the next year or so is to preserve the good parts of the system while embracing necessary change. Paulson's willingness to throw the dice has made the world hold its breath, but it shows that he knows what the stakes are.