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.