Tuesday, December 14, 2010

An Unusual Approach to the Bank Bailout: Facts (Part 1)

Just over two years ago, President Bush signed the Emergency Economic Stabilization Act of 2008 (aka the bank bailout bill), which among other things created the much-misunderstood TARP program. It’s hard to imagine a more reviled piece of legislation:
  • Tea Partiers hated it for its interference in free markets and spending of public money.
  • Liberals hated it for its handouts to the very institutions that caused the problems in the first place.
  • No one liked that it rewarded terribly risky (and ultimately wrong) behavior.
But in spite of all the noise, do we actually know whether or not this bill worked? Did it do what it was supposed to? Can we just cut through the opprobrium and get to the facts? To do this, I’ve listed the various objections to the bank bailout, and then tried to evaluate each objectively:
  • We can’t afford it.
  • It creates a “moral hazard.”
  • It didn’t work.
  • It rewarded the people who caused the problem. Tomorrow
  • The government should not interfere in the market. Tomorrow
We can’t afford it
Really? How much?

ARGUMENT: We can’t afford $700 billion to prop up banks at a time of trillion-dollar-debts and billion-dollar (at the time, now trillion) deficits.

There’s only one problem with this argument: the bailout isn’t going to cost anything close to $700 billion. At its height, only $356.2 billion in TARP funds were committed. (See this chart from CNN for a complete accounting.) Many of the institutions have paid the funds back, and the government has sold its stakes in various institutions (making profits along the way). The result is that according to the latest estimate from the Congressional Budget Office (CBO), the bailout is likely to cost just $25 billion. Nothing to sneeze at but a small part of a $3.5 trillion budget.

One caveat: the American International Group (AIG) bailout is (mostly) separate. AIG received $44.8 billion from TARP, but a total of $127.4 billion when other support is included. That said, the latest CBO estimate suggests it will only cost $14 billion.

It creates a “moral hazard”

ARGUMENT: By propping up these institutions, rather than allowing them to fail, we create a “moral hazard” encouraging further excesses since these banks aren’t facing the full cost of their mistakes.

Moral hazard is the tendency of individuals or institutions to act differently when they don’t fully share the risk of an activity. For example, in the health care world, there is a high level of moral hazard as the people incurring the costs for medical care are seldom the ones who pay those costs. There is therefore every incentive to seek many tests and treatments, regardless of cost or effectiveness.

In financial terms, deposit insurance poses a kind of moral hazard: knowing that the FDIC (or equivalent body in other countries) will back deposits to a certain limit, there’s little incentive for people to pay attention to the financial health of a particular bank. (I’m not advocating the elimination of deposit insurance: just noting that there is a moral hazard.)

There is definitely something to this argument when it comes to the bank bailout. By stepping in and rescuing these institutions after they had screwed up so egregiously, it does send that message that taking huge risks with other people’s money is okay as the government will back them up because “they’re too big and important to fail.”

While this is a strong argument, it is not enough to offset the need for a bailout (although it does support the argument that the bailout should have been done differently). Once Lehman Brothers collapsed in September 2008 (after the government decided not to intervene), the entire international financial system teetered on the brink of total collapse. If the collapse had occurred (i.e. if the government hadn’t intervened), the vast majority of economists of all political stripes agree that the recession would be a depression. In other words, the impact of not intervening would have been far worse than the moral hazard of the bailout.

It didn’t work

ARGUMENT: The economic situation worsened after the bank bailout. A big reason for this is that the financial institutions receiving bailout funds did not turn around and begin lending again. This lack of credit (critical grease in the U.S. economy) has lengthened the crisis.

There’s more than a bit of naivete in the notion that passing this bill would magically end the recession. The modern economy is unbelievably complicated, and there’s quite a bit of inertia involved. Getting it to turn around is likely trying to reverse an oil tanker. It can take months or years for government economic policies to have any impact – positive or negative. And it’s almost never clear exactly how much credit (or blame) these policies should receive.

That said, it’s easy to see why this argument carries so much weight: things did get much worse. Unemployment was 6.2% in Sept. 2008 (Bureau of Labor Statistics); it peaked at 10.1% in Oct. 2009, and remains stubbornly stuck near 10%. GDP declined 6.8% in the 4th quarter of 2008 (i.e. the quarter in which the bailout was put into law), and a further 4.9% in the 1st quarter of 2009 and a small decline in the Q2-2009 before a slow increase since (Bureau of Economic Analysis). Home prices fell (not a bad thing, in my opinion, given the irrationality of this market, but obviously painful for those who needed to sell) and foreclosure rates rose.

The real issue is whether the situation would have been better or worse without the bailout. On this point, there appears to be little disagreement among economists (at least as far as I can find): almost universally (whether liberal, moderate or conservative) they agree that the bailout stabilized the situation and, while it may not have prompted credit markets to return to normal levels, it kept the entire system from seizing up.

Tomorrow: Rewarding those who caused the problem, government interference in the market, and conclusions

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