The Asian bond market crisis halved the value of the South Korean won on the dollar. Photo: micmol (flickr)

"Too big to fail." We’ve all heard it. It’s why the U.S. government bailed out some the world’s largest banks in 2008. And the largest U.S. automakers in 2009. But where did we get this idea that our governments can and should bail out private companies in a free market? Here's how the seeds were planted more than 70 years ago that made bailouts not just legal, but seemingly essential. This is Act 4 of our four-part exploration.

While risk invites danger, it can also bring success. Banks’ confidence in throwing their capital around gave all of us cheaper credit and injected much needed money into emerging markets and developing countries. From 1991 to 1994, the amount of foreign capital injected into developing countries in Latin America and Asia quintupled to $670 billion, the Journal of Economic Perspectives reported. Banks were bullish on the developing world, and their risks brought great rewards to creditors and debtors alike.

But obviously, the more risks you take, the more likely you are to mess up. Combine consumer confidence that "their" money will be insured with banks’ confidence that “their” money will be insured, and the results can get pretty dicey. Remember that this period also saw the government scaling back its role as a bank watchdog. The idea was that free and open markets would produce the best results for everybody, which is often the case. But with the government promising to protect depositors and banks from their mistakes while declining to police their risky behavior, the invisible hand was, well, nowhere to be found.

This trend, in hindsight, made it all the more likely that the Fed would eventually have to realize its promise to bail out big banks. Two events in 1998 did just that. The first was a domestic event in the United States. Long Term Capital Management (LTCM) was an important hedge fund that was founded by two Nobel Prize-winning economists. In 1997, it was averaging 40 percent profits per annum.

But remember the legislation passed during the Great Depression to regulate banks and prevent another crash? The fine print of that legislation specified that hedge funds composed of under 100 shareholders were basically exempt. As a result, most hedge funds in the United States, including LTCM, ensured they had less than 100 people managing their vast sums of assets. Fewer eyes on each investment made all of them riskier. In this world, "success" meant huge success—billions-of-dollars-in-profits success. But failure would spell catastrophe.

Disaster struck LTCM in 1998 when Russia devalued the ruble and declared a moratorium on all future sovereign debt repayments. The value of emerging market bonds—the ones on which LTCM had bet biggest—plummeted. As LTCM approached the brink of failure, it called the Fed to see what kind of a deal it could strike. The solution they found mimicked what would have happened in the private sector, but with better results for LTCM: The Federal Reserve negotiated for a group of private banks to buy out LTCM and inject it with equity. By the next year, the firm was making profits again.

That same year, the crash of Asian bond markets prompted Asian governments to step in and stop the subsequent run on banks that was exacerbating the bust of those bond markets. Just as the U.S. government had promised to save troubled banks, world governments were now doing the same. And in most countries, developed and developing, these bailouts entailed the merging of already huge banking institutions.

The subsequent 10 years saw much consolidation occurring around the world, with banks and other financial institutions merging to reach the economies of scale that enable huge profits. As Andrew Ross Sorkin explains in his new book Too Big to Fail, in 2007 “the financial services sector had become a wealth-creation machine, ballooning to more than 40 percent of total corporate profits in the United States.” As the banks profited, so did many of the people to whom they lent.

Yet while we all were able to live better through cheap credit, we now have to pay up while facing the largest recession since the Great Depression. Both sides of the ideological divide have legitimate views on how we got where we are. However, our future will depend on where we go next.

Ben Osborn is a 2011 graduate of Lewis & Clark College in Portland, Oregon. Read his other contributions to Global Envision.