Resident Scholar  Vincent R. Reinhart

The resources of the U.S. government are vast, but not unlimited. Thus far this year, officials have put federal funds at risk to facilitate the takeover of an investment bank, Bear Stearns, and to provide unconditional support to two government-sponsored enterprises, Fannie Mae and Freddie Mac.

At some point, the government had to say enough. That point came this weekend.

Treasury and Federal Reserve officials gathered the reigning titans of Wall Street and told them that the solution to the problems some had with insufficient capital had to come from within the private sector. No such solution was forthcoming. And now there are two fewer independent investment banks. Lehman Brothers, a 158-year-old firm that started by trading cotton, is bankrupt, and the thundering herd of Merrill Lynch brokers will now answer to bosses at Bank of America.

These two giants will be missed. Even so, this was the right time for the government to draw the line.

Authorities typically ask three questions when considering intervention. How long have the firm's problems been common knowledge in the market? How sophisticated are the firm's investors? And how interconnected are the firm's transactions with those of other firms? Authorities evidently made the determination that Bear Stearns was too interconnected to fail and that some of the investors of Fannie and Freddie, notably foreign official entities, were unsophisticated and skittish.

Those judgments can be second-guessed. But one thing is clear: Lehman did not cast a long enough shadow over markets to warrant support. And Treasury Secretary Henry Paulson and his colleagues are to be congratulated for the courage to make that determination.

When the safety net was pulled this weekend, bankers looked at their balance sheets with considerably more suspicion than before this weekend. The result was that Lehman was left at the altar, and Merrill Lynch had to reach out for a suitor.

The critical message for all of us to understand is this: There are still major losses in securities portfolios on the balance sheets of major U.S. financial firms. Until these firms get more capital to cover the losses, they will be unwilling to support market activity and will likely take active steps to shed assets.

The other thing to understand is that, in coming days and weeks, the resolve of officials at the Treasury Department and the Federal Reserve will be tested again. Some will counsel that there are insurance companies that are too interconnected to fail. Or that depositors at some large regional banks should be protected beyond the Federal Deposit Insurance Corporation's limit of $100,000 per account.

Backbone is necessary. And the orderliness with which financial markets have thus far absorbed this weekend's shocks should stiffen these officials' spines.

And yet the situation has been clouded by the adventurism of some local governments, as witnessed by the state of New York's actions to allow the insurance firm AIG to borrow money from its own subsidiaries. If the federal government seems reluctant to finance more bailouts, enough shopping will find a state willing to bend the rules. This is not the time for a piecemeal approach.

Government officials at all levels have to stand back and watch as the market matches those who have capital with those who need it. And they have to be aware that there may not be enough capital in the near term to put at risk relative to the losses on financial institutions' balance sheets. In other words, some government aid might ultimately have to be directed toward financial firms whose failure would otherwise threaten the financial system.

The politicians now running for office should also appreciate that their grand ambitions for new spending programs or tax cuts may have to be tempered by the need to rescue financial firms. They should be thinking now how to engineer that help at the least cost, to limit the odds of setting bad precedents, and to make lasting reforms to prevent a repetition.

Those currently in power need to remember that modern markets move quickly. They may not be able to pass the problem to their successors. U.S. history and the international experience teach a hard lesson: Delaying the resolution of financial crisis only makes it more costly.

Vincent R. Reinhart is a resident scholar at AEI.