When success is seen as failure

Out of every political and economic crisis comes a new conventional wisdom that proves to be damaging for years or decades to come.  From the Great Depression people wrongly learned the lesson that the New Deal programs were necessary to bring back the economy, for instance.

Possibly the most dangerous CW coming out of the recent financial crisis is that the bank bailouts of 2008 weren’t necessary.  As with any large scale effort, there were a lot of individual bailouts that were probably wrongheaded.  Indeed, in the midst of any war, it is hard to make the right choices on every battlefront.  This is certainly true of the government’s response to the financial crisis of 2008.  I believe strongly, for instance, that GM should have worked through its problems in bankruptcy (like other poorly run companies), rather than having Obama step in, force a sweetheart deal for unions down the throats of share holders, and put a lot of money at risk that could have been used elsewhere—such as in taxpayers pockets.

I’m willing to forgive the Feds these excesses, however, because of the magnitude of the crisis.  The critical moment in those scary Fall days was when Lehman Brothers went under and no one stepped in to rescue them.  Writing in Newsweek recently, Fareed Zakaria reminds us what happened:

Consider the facts. After the fall of Lehman, credit froze in the U.S. economy. Banks stopped lending to anyone, even Fortune 500 companies with gold-plated credit. People couldn’t get consumer and car loans at any price, businesses couldn’t get short-term loans to meet payroll. Private-sector borrowing—the lifeblood of modern economies—fell from 15 percent of GDP in late 2007 to minus 1 percent of GDP in late 2008.

The effects on the broader economy were immediate. GDP shrank by 6 percent in one quarter. Some 1.7 million people lost their jobs, the biggest drop in employment in 65 years, which was then exceeded in the next quarter when 2.1 million jobs evaporated. The net worth of American households decreased by $5 trillion, falling at the unprecedented rate of 30 percent a year. The worldwide numbers did not look much better. The contraction in global trade in late 2008 and early 2009 was worse than in 1929 and 1930. In other words, we were surely headed for something that looked like a Great Depression.

During a few scary hours one day that Fall, there was even what seemed to be a run on money market funds.  Without a quick and massive injection of capital into the money market that day, the bottom might have truly fallen out entirely from the world economy.  The other rescue efforts were less intense, but also necessary.

Now we have politicians running away from TARP—one of the rare moments in Washington when politicians got together in a time of crisis and actually did something necessary.  The crisis was a multi-causal event, but it was and is clear that there had developed massive systemic risk in the mortgage market that had taken in numerous large and important institutions.  I’m a believer that markets should be allowed to correct themselves, but I’m not under any fantasy that those corrections are quick and painless.   People need to suffer market discipline, to face the consequences of the risks they decided to take, but a desire to punish the wrongdoers is sometimes less important than the need to stop the bleeding.  Sometimes kids who do stupid things need to be punished; sometimes they need to be rushed to the hospital.  In the Fall of 2008, the financial sector needed hospitalization.

Without TARP and the massive increase in the monetary base engineered by the Federal Reserve (the latter being the most important), the recession would have possibly been vastly worse than it already has been.  We don’t know that for sure, but to assume otherwise would have been a completely unacceptable gamble.  As it turns out, the TARP funds will be mostly paid off (I heard an estimate yesterday that the net cost to taxpayers will end up being around $30 billion).

Designing the appropriate policies to minimize the types of risks that caused the crisis from occurring again is really tricky, I think—beyond my pay grade, as the President would say.  But I think the incentive problems (big institutions being careless because they except to be bailed out) are a risk we can live with.  The greater risk is that people’s anger about bailouts will teach politicians exactly the wrong lesson: that they shouldn’t act in the face of crisis.  That, in the long run, may be the greatest tragedy of the financial crisis.

4 thoughts on “When success is seen as failure

  1. If the conventional wisdom is that the bailouts were a mistake, that seems to me only among those holding the unconventional wisdom that nobody is smart enough to figure out how to manage the financial sector of the economy, let alone the economy itself. Amongst those those who believe there are such people, it seems to me the view you are defending is CW.

    In any event, your view here seems to me profoundly unwise. Leave aside the issue that there is no Constitutional authority for any of this to have been undertaken. If you believe in the rule of law, then it is beside the point whether you think the consequences of massive violation of legal constraints had good outcomes or not. But the ship containing the rule of law has long since sailed; it didn’t bother anybody at the time and is unlikely to now. So ignore it. Also ignore the fact that some folks who saw themselves as in possession of a Really Good Idea believed the goodness or necessity of that idea justified them in coercively taking money from me and my children (and you and yours, but you seem not to mind). That’s a massive moral problem, but that too is unlikely to bother anybody now more than then.

    Instead, focus on the claims themselves. The financial sector is a system of massive complexity. Neither you nor I nor anybody else know what the counterfactuals are here. You might be right that massive trauma was averted. Or you might be wrong and what happened was simply the next contribution to an even greater trauma down the road.

    But it’s not like we know nothing. We know, I think, two things:

    1. We know that we have guaranteed creditors of large financial firms immunization against loss of loans at risk. They were pretty sure of it before, but they are certain of it now. And we know what the effects of immunizing against loss are (see the S&L failure in the 80’s). We know what are the effects of replacing prudence with regulation, and we know that without doubt we will continue to do so (there never will be a time at which we don’t put the bleeders in that hospital).

    2. We know that smaller financial institutions, lacking those guarantees, will be much less competitive because of the substantial risk premium they face. That secures oligopoly in the financial sector. If you think market discipline matters, it’s a shame that it has been all but ushered out the door.

    3. We know that the regulation that we put in place now will succeed in preventing a crisis from occurring in exactly the same way (that would have been certain anyway, had we allowed firms to fail), but will fail in preventing some new crisis, very likely larger in scale, with causes we cannot now anticipate. Unless you think that we are somehow smarter than the geniuses who guaranteed against this crisis in 2004, or any of the previous works of genius, building regulatory Maginot lines against the last cause of massive financial and economic disruption. I think: if you don’t know that attempts to regulate our way out of the fix we’ve gotten ourselves into by gutting the discipline of prudence, you’re simply not paying attention.

    In short: even if you’re right about the immediate benefits vs. costs of TARP etc., that’s just another instance of the seen vs. the unseen. We should know better. But that’s unconventional wisdom.

    1. I don’t think keeping the financial system alive is as constitutionally problematic as you do. A few points in the Constitution suggest that the government needs to establish means for markets to exist (such as by establishing currency). It is hard to imagine how allowing a catastrophic depression fits any definition of promoting the general welfare.

      I agree that we cannot know the counterfactuals. Perhaps the market would have righted itself, unlikely as that seems. But the risk of a total meltdown was hardly implausible.

      On your list of things we “know,” I definitely disagree with you on point 1. I don’t think the big firms feel immunity (especially given the public backlash against the bailout). The bailouts were a correction for systemic problems in the system, not for idiosyncratic bad risks that they might take.

      I agree with your point about the competitive disadvantage of the smaller firms, though I don’t think we have eliminated market discipline.

      I do agree with point 3, that any regulation will provide us complete protection. That would be a fool’s dream. I do think, however, that we could design a simple regulatory scheme that makes widespread crises uncommon. Even our flawed system we have had in place since the Great Depression (as well as its reforms) worked reasonably well–until it didn’t. I don’t think we are headed into an era where there are frequent financial crises. Rescuing the markets a few times a century doesn’t strike me as that big of a regulatory failure.

  2. You are correct and this is a wise post. I think the biggest cause of the financial panic of September was the way political considerations about reactions to bailouts caused Paulson to handle the Fannie/Freddie conservatorship and then to fail to save Lehman. Wiping out the Fannie and Freddie preferred, which were given Tier I capital status in bank balance sheets (30:1 leverage allowed), put a huge strain on banks that owned their paper and caused them to shrink the asset side of the balance sheet i.e. call in loans and make less loans. In many cases, those loans were to shadow banking players which multiplied the effect as credit assets began to be dumped. That credit asset fire sale meant that asset-backed cp began to be redeemed and not rolled over, which made the problem spread to money market funds. Then you throw in the shock to derivative markets from Lehman and you have started a full blown panic.

    TARP was a good program overall. Its net cost was negligible relative to the fisc and in any case the benefits considerably outweighed them. People forget that the federal government is by virtue of its tax take a 20% minority investor in the economy, and if you take state and local governments into account the stake is even higher. People also forget that given our tax structure the persons who provide most of the money for the TARP bailout are the persons who benefit most from capital market health so it’s hardly a bad use of fiscal resources.

  3. Sven, market discipline is defined as allowing unprofitable firms to fail. Market discipline among the big firms has been eliminated.

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