Cochrane, Booth School: Too big to fail is the key to 'crisis'

We are left with only one plausible explanation for why
Lehman’s failure could have had such wide-ranging effect:
After the Bear Stearns bailout earlier in the year, markets
came to the conclusion that investment banks and bank
holding companies were “too big to fail” and would be bailed
out. But when the government did not bail out Lehman, and
in fact said it lacked the legal authority to do so, everyone
reassessed that expectation. “Maybe the government will not,
or cannot, bail out Citigroup?” Suddenly, it made perfect
sense to run like mad...

Once everyone expects a bailout, government has to provide
it or else chaos will result.Obviously, in this view there is nothing
inherently “systemic” about the behavior of Lehman
Brothers or other large banks.What is systemic is the expectation
of a bailout. The policy question is simply how to
escape this horrible moral-hazard trap.

The tarp mess did not help. Federal Reserve Chairman
Ben Bernanke, Treasury Secretary Henry Paulson, and
President Bush got on television and said, basically, “The
financial system is about to collapse. We are in danger of an
economic calamity worse than the Great Depression. We
need $700 billion, and we won’t tell you what we’re going to
do with it. If you need a hint, we justmade it illegal to shortsell
bank stocks.”

These speeches should be remembered as a case study in
how to start a financial crisis, not how to relieve one....