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Were the bailouts a good idea?
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.
Posted by Tyler Cowen on August 25, 2009 at 06:38 AM in Economics | Permalink
Comments
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.
Posted by: David at Aug 25, 2009 7:37:46 AM
"If you are a libertarian, is not our current course more favorable for liberty than would have been a repeat of 1929-1931?"
It truly depends on the time horizon in which you situate your question. In the near term, it would seem that things are more favorable for liberty than if we had followed the typical libertarian doctrine and allowed things to deteriorate unchecked, leaving the market to total meltdown. But, looking out a little further, one pauses to realize that to solve a problem rooted in interest rates being brought to historically low levels (by Greenspan), his replacement brought interest rates to historically even lower levels...while the administration presided over policies to encourage people to purchase homes who otherwise would not likely have done so (sound familiar?). So, to reiterate, in the near term we all breath a sigh of relief, but projecting into the future we must accept the fact that we had an opportunity with this crisis to cease the perpetuation of a boom-bust-cycle and missed it. Drinking a bloody mary to stave off a morning hangover makes you feel better now, but eventually you are going to have to deal with the pain.
Posted by: John at Aug 25, 2009 8:04:19 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.
Posted by: jj at Aug 25, 2009 8:09:13 AM
It obviously would have been beter in 1929 to throw the bums out and install libertarians. Same for today. Unfortunately that's not on the table.
You are asking the perennial question. Is it better to fight a controlled retreat or win Pyrrhic victories. As usual, the answer is it depends. And it's still just a thought exercise. In this case, contra the regulation hawks view that libertarians have the government by a choke hold, we obviously have no choice in the matter other than griping on comments pages.
It's also a bit of a cheat to say we need the things that soften the blow of crises in boom times. It would be nice for example to not run deficits EVERY year. And, contra the regulation hawks again, Alan Greenspan's shining achievement from my libertarian point of view was convincing Bill Clinton to balance the budget.
Posted by: Andrew at Aug 25, 2009 8:11:13 AM
http://unqualified-reservations.blogspot.com/2009/04/america-zombie-nation.html
Posted by: josh at Aug 25, 2009 8:19:04 AM
"Is not our current course more favorable for liberty than would have been a repeat of 1929-1931?"
Yes, it is.
"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?"
Maybe foreign banks would.
"Is it that natural market forces would have somehow avoided a wrenching surprise deflation?"
It depends on what you call "wrenching".
"Do you think the authorities for some reason would have not nationalized the major banks?"
No, I don't think so. I am also not surprised that "you" did the bailouts.
"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?"
Bad.
No matter. The bailouts were a bad idea.
Posted by: Lib at Aug 25, 2009 9:06:01 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?
Posted by: swg at Aug 25, 2009 9:12:16 AM
"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?"
Personally, I don't feel I know enough to say if the bailouts were a good idea or not. But I feel that I don't think it's fair to say "if we wouldn't have done the bailout that actually occurred, then a worse one would have happened." In that case yes, I think every libertarian is pro-actual-bailout and against-hypothetically-worse-bailout. But it might also be that they are against all bailouts, in which case they could respond that when Congress and Nancy Pelosi proposed the hypothetical-worse-bailout, they would be against that as well.
It is like telling an anti-war proponent: "well, I know you were against invading Iraq in 2003, but don't you realize that we would have just had to invade in 2005, and that would've just been worse?" Perhaps it is true that the bailouts or the war were truly necessary at some point, but this isn't a good argument against people who are against them, actual or hypothetical.
Posted by: Brian Moore at Aug 25, 2009 9:40:15 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.
Posted by: Mike at Aug 25, 2009 9:42:08 AM
As we can now see, the bailouts were indeed sufficient to stabilize the financial system. Sufficient, but excessive. Buying troubled assets would also have been sufficient, but would not have been blank checks allowing banks to do what they wanted with federal money (such as paying bonuses). Most wall street banks are still closed for business and will not extend loans. So the system has stabilized, but who are the beneficiaries aside from the banks themselves?
The other major issue that is sometimes touched on, but not nearly often enough, is the moral hazard created yet again by bailing out the financial sector. If they know that they cannot lose (and continue to issue bonuses despite making firm-wide losses), they will never learn!
Posted by: zelfman at Aug 25, 2009 9:43:52 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.
Posted by: Floccina at Aug 25, 2009 9:46:19 AM
I think, on balance, the bailouts were a VERY bad idea AS REALIZED.
A very different set of bail-outs, handled differently, might have been a net positive.
As I've said many times, a bankruptcy is a very rational, predictable, rule-driven process. Many of these banks should have been exposed to the process, at least with some mitigation for the ramifying effects through the larger economy.
The idea that any enterprise is "too big to fail" is both false and extremely dangerous. The bail-outs, among other bad things, promulgated that myth.
Posted by: Ragspierre at Aug 25, 2009 10:10:41 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.
Posted by: dave at Aug 25, 2009 10:14:20 AM
Zingales/Hart-style debt-to-equity swaps for big financial firms would have been better. The Treasury considered such swaps but rejected them for political, not economic reasons, as Treasury's Swagel himself says in the link in my name.
The political capital that Paulson and Bernanke put into the TARP would have been much more efficiently spent tinkering with bankruptcy laws just enough to make Zingales/Hart doable. We would have had free-market bank recapitalization, a *persistent* lowering of debt-equity ratios, and all without months of radical regime uncertainty and regime worsening. Hard to see how that's worse than the status quo.
Instead, we have a regime where personal power is more important than before, where big banks have a decent risk of zombification (because their debt levels are still massive), and where our big investment banks have converted into commercial banks. Accordingly, it's likely that the recovery will be weak, not Japan-weak, but weak nonetheless. Balance sheets matter (Fisher's "Debt Deflation" paper still deserves rereading), and institutions matter, and both are worse than before the Paulson Panic.
Debt-to-Equity swaps plus loose money sounds like a recipe for success--and I think one can read Friedman/Schwartz as supporting such a policy. After all, they supported FDR's bank holiday, which they said raised velocity. Bank shutdowns=confidence boost, in their view. Not the whole story, but this is just a blog comment after all. More on this topic in my piece in U.S. Exchequer last fall.
I think John Taylor is right: Much, perhaps most of the fall in stock prices and the rise in risk premia in September was caused by Paulson, and I believe that much, perhaps most of the recovery in stock prices was caused by a modest return to the rule of law in the financial sector, perhaps orchestrated by Larry Summers, Christy Romer, and the rest of Obama's econ team. Hard to test, but I recall the radical uncertainty of the financial talking heads back in September, and Politico noted this summer that the Obama Administration made a conscious decision to cut back on financial populism, reversing the worst of their Winter Offensive.
Hard to give them too much credit for just stopping their own awful behavior, but then again, half of good economic policy is just getting your own bad guys to be quiet.
Posted by: Garett Jones at Aug 25, 2009 10:32:53 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.
Posted by: Sean M at Aug 25, 2009 10:38:37 AM
Think of all the poor union leaders in Detroit. If it hadn't been for the bailouts then they would be out of work and Detroit's economy would be even worse...instead they are running GM and still making good money...pheww...see this is much better for liberty. We should also give unemployed GM workers new jobs like head of the NY Fed...we just did? oh this is great...things are really coming around. Who knows how this will turn out but things are going great so far so I'd have to say this has been some great policy.
Posted by: Gabe at Aug 25, 2009 10:46:49 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.
Posted by: meter at Aug 25, 2009 10:46:49 AM
"If you are a libertarian, is not our current course more favorable for liberty than would have been a repeat of 1929-1931? "
COUGH STRAW MAN
Posted by: Doc Merlin at Aug 25, 2009 11:27:35 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?
Posted by: Brian at Aug 25, 2009 11:52:59 AM
If THEY were to listen to us about bailouts, couldn't they listen to us regarding panics and inflation and...
But what we actually got is "even the free market fundamentalists are for government intervention during the crisis, look at Alan Greenspan and Tyler Cowen ( ;O ) therefore their entire philosophy is hypocritical and the government ought to regulate everything."
Bailouts aren't a good idea if they are just part of the broader cycle that keeps spinning out of control.
The outstanding thing was that the government managed to have massive bailouts AND panic. I'm not sure how people can be so sure the panics would have been much worse. The banks already didn't trust each other at all. Can you get negative trust? People think letting Lehman fail was a mistake, but it was a mistake in the regime of a broader decision to go for full bailouts. A little poison in the well.
Posted by: Andrew at Aug 25, 2009 12:00:21 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.
Posted by: bill at Aug 25, 2009 12:09:05 PM
Tyler, really? you have that much confidence and conviction in your assessment of the economic and political situation that you would advocate large scale corp subsidies and overreaching political powers of a tenuous agency to "save the financial system?" If that's not hubris I don't know what is...
Posted by: paul at Aug 25, 2009 12:39:10 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.
Posted by: Gabe at Aug 25, 2009 1:15:07 PM
I second the comment by Paul: "If that's not hubris I don't know what is..."
Worse - Tyler's answer to his own question and most of the responses whether for or against reveal how corrupting it is to be a product of the government education system. The idea that liberty can only be preserved by destroying it is absurd. Tyler's reason for surrendering liberty is that it could have been worse: "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?"
It sounds sad, pathetic, hopeless...it sounds like a man without reason.
Posted by: Brian at Aug 25, 2009 1:38:19 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.
Posted by: Commenterlein at Aug 25, 2009 2:10:39 PM
