Were the bailouts a good idea?

by on August 25, 2009 at 6:38 am in Economics | Permalink

Following the renomination of Bernanke, it is worth revisiting this question.  Here is a recent report:

With the FTSE World Banks index up 130 per cent since its lows of
early March, the paper losses that governments in France, Belgium,
Luxembourg and Germany are sitting on have also shrunk. Berlin's 25 per
cent stake in Commerzbank's common equity is now worth only 2 per cent
less than the €1.8bn ($2.6bn) the German government paid for it.

In
spite of criticism of the bail-outs of lenders such as Citi, Bank of
America and Wells Fargo, the Treasury has reaped gains from the coupons
payable under the troubled asset relief programme bail-out funding,
most of which has been repaid.

If another big negative shock comes the government's liability position still could turn out to be much worse.  But if we stop and click pause and evaluate the policy today — the answer to my question is "yes, the bailouts were a good idea."

Without the bailouts we would have had many more failed banks, very strong deflationary pressures, a stronger seize-up in credit markets than what we had, and a climate of sheer political and economic panic, leading to greater pressures for bad state interventions than what we now see.  Milton Friedman understood all this quite well, which is why argued bailouts would have been a good idea in the 1929-1931 period. 

(By the way, some libertarians like to pretend that Milton Friedman blames the Fed for "contracting" the money supply by one-third in that period but in reality Friedman blames the Fed for having let the money supply fall by one-third and not having run a bank bailout.)

If you are a libertarian, is not our current course more favorable for liberty than would have been a repeat of 1929-1931?  If not, I would be curious to hear your counterfactual version of how matters would have proceeded, without the financial bailouts.  Is it that you think the regional banks would have raised the financing to pick up the entire bag and keep the banking system afloat?  Or is it that natural market forces would have somehow avoided a wrenching surprise deflation?  Or do you think the authorities for some reason would have not nationalized the major banks?  Please let us know.

Maybe you think that the bailouts will have disastrous long-run consequences.  And maybe they will, I worry about this too.  But if anyone should know that modern politics can only stand so much short-run panic, it is libertarians and fans of Bryan Caplan's book.  If we had not done the bailouts we did, we would, within a few months' or weeks' time have received a much worse and costlier bailout run by Congress and Nancy Pelosi.  How does that sound?

I can see that Peter Boettke, on his blog, periodically struggles with these questions.  I speculate that Pete even toys with the idea that I am right and that Friedman, a founder of the Mont Pelerin Society, was right about 1929-1931.  But I wonder if he can bring himself to utter those magic few words: "All things considered, the financial bailouts were a good idea.  They would have been a good idea way back when and they were a good idea this time around."

Addendum: Megan McArdle comments.

David August 25, 2009 at 7:37 am

Hmm. No mention of AIG or GM here… No Fannie or Freddie. Strange. Also, most of TARP has been repaid because most of TARP was not needed, and most of TARP was forced on banks that didn’t need it in an attempt to hide from the public which banks were sound and which were ruined, like a big game of Three Card Monte.

My hypothetical counterfactual is that FDIC obligations were always met, so depositors felt less fear than they would have in 1929. Investors in failed banks and derivatives rackets were not bailed out. Fannie and Freddie disappeared and somehow mortgages still got sold. GM’s demise made Ford stronger. In this pipe dream we also learned that seizure, forensic accounting, and auction (call it nationalization if you must) is better than rewarding an entrenched and incompetent management class and the perpetuation of private profits and public losses.

jj August 25, 2009 at 8:09 am

What if we had had a much smaller bailout but much more expansive monetary policy? Say Bernanke didn’t pay interest on reserves, opened the spigot further, and engaged in expansionary and even unconventional monetary policy in the Fall 2008 instead of 2009 to the point where the TIPS market never got to signal deflation? Strong inflation targeting? Aren’t you the one telling us you like Sumner’s views?

And what if a deal had been cut earlier on subprime? Didn’t you once blog on a proposal to have the government back 50 year fixed rate mortgages on old subprimes as a one time thing so that we could stabilize and more important properly monetize the scale of the risky assets?

All this would have cost us less than current bailout policy and the so-called stimulus package.

josh August 25, 2009 at 8:19 am
swg August 25, 2009 at 9:12 am

I think about the same things commenter David does: what about the rest of the bailouts? A 30% return on $10 billion sounds great, but isn’t it a very small percentage of the total bailouts? What about the trillions (!) of dollars to other institutions?

Mike August 25, 2009 at 9:42 am

First, I love how thoughtful the commenters are here. Great work to all!

I agree that the bailout has assuaged much of the suffering that might otherwise have occurred from this financial crisis. Whether this is a good or bad thing depends in some part on if you think that the financial sector needs changes in regulation; a more painful experience will generate more momentum to change the framework. Consider a personal experience we all have – hot items in early childhood. My mother always warned me, “no no, that’s hot, don’t touch it”, but still I would reach my little hand out and try to touch it, but she averted disaster by swatting my hand away from the hot item. That is, until one moment of one day, when I happened to be around something hot, and she wasn’t. I got a fair burn from touching a hot iron, and it hurt like heck and I cried… but you know what? I never touched anything hot out of curiosity again. The moral of the story is that assuaging pain is great, but pain is the most universal teacher we have in our society. It makes us pay attention and provides a highly concrete incentive to stop performing an action.

So, I think that the stage would be set for greater regulatory change if less bailing out had been done, but the positivity or negativity of that is something I’m *certainly* not qualified to judge.

Floccina August 25, 2009 at 9:46 am

It seems that this is a case of what is verses what could be. IMO if the investment banks would have all been allowed to failed they would have in this computer and internet era been replaced by something much better. We may have seen 20% unemployment but we might by now be seeing a recovery based on some creative solutions.

dave August 25, 2009 at 10:14 am

If you think what Japan did was a success because they stretched 1929-1933 over 20 years with no resolution, then your going to love the bailouts.

First, I don’t think the bailouts true cost has been recognized. Everything about the matter is based on delaying tactics. Banks using new accounting rules to keep from writing down securities. There are huge backlogs of foreclosers not being recognized. Option ARM resets will continue through 2011. Commercial real estate will collapse. Growth, if it comes at all, will be slow and unemployment will begin a whole new round of household deleveraging. These loses are real, they just haven’t been acknowledged, just as was done in Japan. The idea of making any money off the bailouts will seem absurd in a few years.

Second, there has been no reform of the business whatsoever. There will likely be none and we are setting ourselves up for another one of these in ten years time.

Lastly, I do not believe the stock market bounce is a result of improving fundamentals. I believe the market is as correctly priced as I did summer of 2007 when I shorted the heck out of it. This is little more then a tidal wave of liquidity trying to find a home and going into anything that can be bought with a mouse click. It won’t solve any of the fundamental issues, and when the current euphoria wears off I think you’ll come back to this post and have to reflect on your shortsightedness.

The correct solution was to take the banks into FDIC receivership. Figure out a reasonable valuation for them, sell them to the public again, and make bank shareholders and bondholders eat the losses while protecting deposit holders. This could be accompanied by real reform.

Sean M August 25, 2009 at 10:38 am

“The correct solution was to take the banks into FDIC receivership. Figure out a reasonable valuation for them, sell them to the public again, and make bank shareholders and bondholders eat the losses while protecting deposit holders. This could be accompanied by real reform.”

I think this route would have been preferable. Why use TARP to keep afloat failing (yes, in present terms) banks? TARP funds should have been granted to the FDIC for the administrative costs associated with placing them in and bringing them out of receivership.

meter August 25, 2009 at 10:46 am

Two words: moral hazard. These bailouts will have hugely negative long-term implications. By the way: when is the next bubble scheduled? I’d really like to get in on this one as I missed the last two.

Brian August 25, 2009 at 11:52 am

My guess is that a libertarian might concede that, in this context, the bank bailout was a good idea. Alternatively, one might argue that, given this context, a bank bailout was the only effective option, as you seem to argue. But is there any way we can change this context going forward? Or are we doomed to continually extricate ourselves from busts by inflating new bubbles?

bill August 25, 2009 at 12:09 pm

Surprised that none of the banking experts on this thread have pointed out that the banks were not even insolvent. The government changed the rules in the middle of the game by insisting on Tier 1 common capital as a new benchmark rather than Tier 1 capital. It was the uncertainty injected into the market by the Government’s inconsistent actions that turned what would have been a mild/sever recession into a full blown panic.

Gabe August 25, 2009 at 1:15 pm

The crazed gang would have killed mom, pop and all the kids too if we hadn’t sacrificed dad and mom, so I guess we made the right call by killing mom and dad. Once they saw us kill our parents, the murderers assumed we were on their side. So se it was actually good policy to kill mom an dad…it was the only practical thing to do.

Commenterlein August 25, 2009 at 2:10 pm

Wow, the comments are way too harsh to Tyler. Too-big-too-fail is all too real, even though many here seem to deny it. The normal bankruptcy process simply doesn’t work for any of the big money center banks or for an AIG – the moment one of them goes into chapter 11, the entire global banking system freezes up. Nobody knows the exposures of the counterparties of the defunct bank or of the counterparties’ counterparties (i.e., pretty much every bank), hence nobody knows where the next domino is going to fall, and as a result everyone goes into cash hording mode. This means that the plumbing of the modern economy has shut down, there is a good chance that the payment system fails, and then we would have gotten a new great depression.

Seward August 25, 2009 at 2:31 pm

Speaking of central banks this is what Milton Friedman writes:

Any system which gives so much power and so much discretion to a few men that mistakes – excusable or not – can have far reaching effects is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without an effective check by the body politic – this the key political argument against an “independent” central bank. – pg., 50

Sean Ryan August 25, 2009 at 3:06 pm

There are really only five giant financial companies that one can properly view as having been bailed out – Citi, AIG, Bear Stearns and the GSEs. Each really needs to be judged as an individual case, but generally speaking, we could have done without the bailouts, and there would have been some further dislocations but the sun would have continued to rise in the east and people would have soldiered on without the country devolving into the post-apocalyptic dystopia posited by the interventionists.

http://www.pecuniarius.com/blog/?p=114

andy August 25, 2009 at 3:42 pm

“If we had not done the bailouts we did, we would, within a few months’ or weeks’ time have received a much worse and costlier bailout run by Congress and Nancy Pelosi. How does that sound?”

As an old gramophone. One of the most famous time was when the German people used this argument this way: if we don’t get fascism, we’ll get russion style communism….

Scott Wentland August 25, 2009 at 4:06 pm

Don’t we need to be more careful about equating “good idea† and “worked†? The bailouts, if they “worked,† may have just been an expensive placebo or painkiller. And, if you were just fed an expensive placebo, and it cured you or eased the pain in the short term… you would be happy that it worked, but you would also prefer a less expensive long term fix, right? You probably wouldn’t call the expensive short term fix a successful remedy anymore than you would call morphine a cure.

Sean Ryan August 25, 2009 at 4:10 pm

The first issue to be resolved is what we mean by bailouts. Cowen quotes from an article that refers to “the bail-outs of lenders such as Citi, Bank of America and Wells Fargo.† But this list is very misleading, as it conflates government dealings with a bank that may well have failed absent government support (Citi), a bank that was always solvent but was strong-armed by government into following through on a wildly overpriced acquisition (Bank of America), and a bank that remained not only solvent but profitable and healthy throughout this entire debacle (Wells Fargo).

If the discussion is to have any meaning, then the idea of a bailout has to be nailed down a bit better than that. The overwhelming majority of banks that took government capital through the TARP, after all, were healthy institutions that didn’t need the capital but were willing to take it based on the initial terms and the active encouragement of their regulators. Most banks will do anything based on the active encouragement of their regulators.

Let me suggest that a bailout constitutes government intervention in a company that had a strong probability of failure absent that intervention. Based on that definition, the list of bailed-out financial institutions would include Citigroup, AIG, Bear Stearns, Fannie Mae and Freddie Mac. The list would not include healthy institutions such as JP Morgan or Wells Fargo, who had TARP funds crammed down their throats, or institutions for which government funds didn’t stave off insolvency so much as shareholder dilution by offering capital on better terms than were available in the market.

For purposes of brevity I will leave GM aside as an industrial company even though a strong case can be made that it is a financial in drag that would have gone belly up years ago but for the cash thrown off by its mortgage operations during the boom.

So let’s go down the relatively brief list of proper bailouts.

Bear Stearns – this qualifies as a bailout in the sense that shareholders were left with $10 per share (negotiated up from an initial $2 bid from JP Morgan), despite leaving the government on the hook for a large share of the firm’s losses. This bailout was not a good idea; Bear Stearns shareholders should have been in line behind the government. Leaving Bear shareholders without the residual $10 per share would have had a minimal effect on either the disposition of the firm or the broader markets.

Fannie Mae and Freddie Mac – many of us (well, many of us free market types; not many of us equity analysts) have predicted for years that Fannie and Freddie were accounting frauds that would leave taxpayers with an enormous tab. The government had little choice but to guarantee their debt, since for years the government had permitted the markets to believe that it would do so in a crisis. These companies should have been wound down long go, and their functions left to the market-based competitors. At the very least, they should have been prohibited from holding such large investment portfolios, which effectively transfer value from taxpayers, who bore underpriced risk, to shareholders, who enjoyed earnings growth from the GSE’s ever-increasing leverage. This bailout, then, is largely the government following through on irresponsible commitments it had already made. What really should have happened was the formal government guarantee of the debt, followed by a commitment to wind down the companies and cede their functions to the JP Morgans and Wells Fargos of the world.

Citigroup – Citi may have survived absent government intervention, but there is a strong possibility that it would have failed. But what the bailout really did for Citi was give Vikram Pandit a reprieve from having to break up Sandy Weill’s frankenfirm in a highly illiquid market. Sandy Weill manufactured the illusion of earnings growth by making an unending string of acquisitions (which were never intergrated), taking enormous merger charges to mask operating expenses, and systematically underinvesting in infrastrucure. By the time the hapless Chuck Prince took over, the wheels were already beginning to come off. Come the day of reckoning, I would much rather have seen the government leave its hands off Citi, and Citi shareholders suffer the consequences of lousy management and a somnolent board. The most likely outcome? Citi stays afloat by selling off the crown jewels of the franchise such as Banamex at sub-optimal prices, and shareholders are left with a solvent company, albeit one with reduced earnings potential.

That leaves AIG. Allowing AIG to fail would indeed convulsed global markets. And shareholders have effectively been wiped out (it is really only a matter of time before the stock is formally worthless). This is the one bailout where there is really no chance of the government ever recouping its investment. The trouble in trying to evaluate this bailout is that we don’t really know with any specificity what AIG’s true liabilities were. Would it have set off a chain reaction of insolvencies throughout the financial sector? Or would shortchanged creditors and counterparties have simply taken their lumps, and filled balance sheet holes with dilutive capital like everyone else? Probably some of each, but my instinct is to say the government should have kept its checkbook closed and let the chips fall absent compelling evidence to the contrary.

What about political fallout? It’s a good question, but one that can only be answered with rank speculation. I can offer an informed opinion on the financial problems and prospects of the companies caught in the maelstrom, but have no special insight into what the counterfactual political developments would have been. But then, neither does Mr. Cowen. Maybe Congress would have overreacted and sought to nationalize more banks. But then, I can argue just as plausibly that the populist rage at bailouts would have reached a fever pitch that much sooner and caused a blue dog – GOP coalition to block such actions.

Mr. Cowen also drafts the late Milton Friedman into the debte, and suggests that he would have supported the current bailouts since he suggested bailouts may have been wise at the outset of the Great Depression. I will not presume to speak for Professor Friedman. But I will cite his legendary colleague, Anna Schwartz, who recently commented that

“the trouble with the way the Fed operated when it rescued Bear Stearns, the market then believed this was a signal of the way the Federal Reserve would perform. If the Fed and the Treasury made a candid statement to the market: We will help a bank, which basically is solvent. We will not do that for a bank, which is on the verge of bankruptcy. And then the market understands there are principles. That’s why when Lehman Brothers was permitted to fail, the market was simply bewildered. Because here you had treated Bear Stearns in this kindly fashion, and what reason was there not to do the same when Lehman Brothers arose?

If anyone is entitled to offer a view that might correspond with Professor Friedman’s, it is Ms. Schwartz. She doesn’t sound like a big fan of bailouts to me.

Tristan August 25, 2009 at 4:33 pm

Yeah, things are great. We transferred an unknown amount of financial liabilities from the institutions to the taxpayer and turned a banking crisis into a debt and currency crisis. Let’s do it again next year.

Sorry folks, in my day when banks screwed up they were nuked – shut down over the weekend and their assets taken over by the RTC to satisfy the taxpayer’s obligations. That’s what should have happened here, so please don’t give me Chairman Obama’s old strawman because hopefully you have a more intelligent audience that understands that yes, there are more options besides “lets do something” and “lets do nothing”.

sugarfree August 25, 2009 at 4:54 pm

I don’t think there’s anyone more deluded than a libertarian.

The responses to Tyler have pretty much been variations of “Nuh uh!” and “WHY DO YOU HATE LIBERTY.”

Sean Ryan August 25, 2009 at 5:28 pm

Matthew – I’ll grant you that just about every financial institution has failed to properly mark its balance sheet. But leaving the implausible valuations asserted by managements to the side and applying very severe haircuts to the purported book values, JPM and BAC have been and remain solvent.

Don the libertarian Democrat August 25, 2009 at 6:10 pm

I won’t speak for Milton Friedman, but I do like to actually quote him. However, on the Fed, he disagreed with Anna Schwartz in various ways. I know, because I agree with Friedman on this:

http://www.cmc.edu/somc/anne_schwartz_042009.pdf

Here’s another disagreement, that Scott Sumner points out, where I also agree with Friedman:

http://blogsandwikis.bentley.edu/themoneyillusion/?p=2102

Finally, we are, in my view, following the Chicago Plan of 1933, in fighting this crisis. I’ve never been sure if he agreed with his teachers or not.

I think that Prof. Cowen’s post makes good points.

Patrick August 25, 2009 at 8:17 pm

Responding to one of the first comments that said “Fannie and Freddie went a way but mortgages still got sold.” Not attacking your broader argument, but your wrong about your assertion that they went away.

They still exist and they provide financing for 80% of the mortgage market b/c the Feds have backed them with conservatorship authorization that was provided FHFA legislation that was passed in June or July 2008, just before the fall banking crisis.

The only reason anyone could get mortgages for the last six months is b/c the federal government stepped in. Without that action, no one would have been able to buy a home. Private lenders were not stepping up in the tumultuous credit environment.

Henri Hein August 25, 2009 at 10:06 pm

Why do you assume things would have been worse without the bailouts?

I don’t think that is established. The bailouts, the stimulus packages, an overactive congress and an aggressive, meddling central bank all contributes to uncertainty and doubt. Why would anyone invest in such an environment?

Conversely, had they let Bear Sterns collapse and focus on their only job, namely, keep the currency at value, then investors, managers and entrepeneurs would have known exactly where they stood. Bear Sterns and AIG would have been restructured and the economy would have picked up again.

Maybe that is optimistic, but how do we know? What I noticed at the time was that with every bailout, every congressional vote, every Paulson move, things got worse. Things looked pretty good in the quiet times in between. Without a meddling Fed, we would have had a pretty run-of-the-mill recession. It was precisely the bailouts and the stimulus that made this disaster.

erghammer August 26, 2009 at 1:07 am

Here is a thought experiment I keep running in my head…

Instead of “when in doubt, bail it out” the motto is “if you have to bail, then let it fail”. You still have $2 trillion in deficit spending to throw at the problem. Instead of committing that $2 trillion to prop up insolvent enterprises, the government instead commits that sum to supporting anyone who loses a job because of the incipient depression.

Or think of it like this: instead of trying to keep the Titanic afloat with duct tape, bailing wire, chewing gum, smoke, mirrors, and a $2 trillion subsidy, you invest in a lot of lifeboats.

How do things play out now?

Unemployment shoots through the roof, perhaps even doubling the level it’s at now. But that’s what the massive welfare program is for. We have already committed huge sums for welfare. In my hypothetical, subsidies go directly to the people who need them. In the real world, much of it gets stolen before it can trickle down. Watching bailed out bankers make off like bandits damages the moral fiber of the republic, although I can’t measure by how much.

Yes, interbank lending dries up because no bank trusts another… but consumer lending continues because all banks know that consumers (up to a reasonable limit) are backed by the full faith and credit of the United States. Extend the national welfare program to include most mortgage payments (eg, some reasonable percentage of what your salary is or was before you lost your job in the depression). There is still money for banking to function. It is now, however, being infused bottom up rather than top down.

Yes, I am aware the politics don’t work. The national welfare program would need Congressional appropriation. The bail ‘em out approach can be carried by surreptitious and arguably extra-legal activities by the Fed and the Treasury. But I won’t let this little thought experiment be brought down by something as trite as lack of political will on the Hill.

One thing I am certain of in the hypothetical: all of the zombie institutions that created the depression will not be able to cause a second one.

PQuincy August 26, 2009 at 2:20 am

This posting and discussion, and the adjacent one on the public option, illustrate why this remains one of my favorite blogs. I disagree with a lot of libertarian ideas, accept some others in part, but above all welcome the chance to look at them prudently, systematically, and intelligently as initiated by the posters on this blog and continued by the commentors!

David August 26, 2009 at 9:58 am

Patrick, I know Fannie and Freddie didn’t go away, just like GM didn’t go away. I was offering a hypothetical “in the absence of the bailouts” scenario. Wasn’t that the assignment?

You say “no one” would be able to buy a home without the Feds and the corrupt MLAs they routed the taxpayer’s money through. I say there’s not much about lending that higher rates and collateral can’t fix.

Jeff August 27, 2009 at 8:41 am

I’m reminded o Harry Browne’s line- “Government is good at one thing: It knows how to break your legs, hand you a crutch, and say, ‘See, if it weren’t for the government, you wouldn’t be able to walk.'”

d4winds February 19, 2010 at 9:58 am

Let ‘em fail & say so loudly, clearly, & repetitively. Two reasons: (1) moral hazard writ very, very large; (2) regulatory capture. (1) is obvious. Due to (2), de facto, implemented, financial regulations will be at best a codification of what the principal players in an industry already believe to be best practices.

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