Last week’s blog showed that taxpayer losses from bank bailouts during the Great Recession are a myth. Instead, they made a handsome profit on TARP capital injections to the biggest banks, helping to pay for the largely ignored multi-billion-dollar losses on defaulted loans to the auto and insurance industries. This post makes a much more important related point. The big-bank capital injections helped prevent the multi-trillion-dollar taxpayer losses that would have occurred if the crisis had produced in a 1930s-class depression. There is no doubt that the next time aggregate demand is collapsing the recent outlawing of temporary capital injections will be repudiated. The crucial question is whether the needed repudiation, now requiring legislative action, will come in time to help prevent an immense depression. We are placing a huge bet on the capacity of Congress to act with foresight and speed in dealing with macro emergencies. History suggests that the wager is a long-shot.
Background. The professed objective of the Congressional reworking of financial regulatory framework is to prevent future Great Recessions. The overall effort has been organized on an apparently inviolate principle. Taxpayers will never again inject capital into big banks. Most notably, the elimination of taxpayer “bailouts” was a central rationale for, and a cheered accomplishment of, Dodd-Frank. Sheila Bair, while head of the FDIC, was one of the architects of that game-changing legislation: “We worked hard to make sure taxpayer bailouts [to big banks] are completely prohibited. I think the language is very tight on that. One of the things that frustrates me with critics of Title II is that they perpetuate the myth of Too Big To Fail by insisting that the government is still going to do bailouts, notwithstanding clear language in Dodd-Frank to the contrary.”
Bair’s confidence is embarrassing. Some uncomplex analysis, rigorously developed in the GEM Project, turns the case made by Bair and her fellow taxpayer champions upside down. Indeed, a bit of intuitive thinking, surly within the reach of highly-placed policymakers, is all that is needed to understand that the effective prohibition of government capital injections into the banking system helps expose U.S. taxpayers to many, many trillions of dollars in losses.
Intuitive thinking. In the wake of the 2008 bankruptcy of Lehman Brothers, many rational investors/lenders became sufficiently uncertain about the macro future to become inactive, suspending acquisitions of financial assets and capital goods. Financial markets quickly froze up for lack of buyers, and asset prices were pushed into a free fall. (Recall that the S&P 500 equity index lost nearly a third of its value in the month following the Lehman bankruptcy.) Sidelined buyers rationally waited for a halt to contracting spending and the emergence of credible market bottoms. The damage to the financial system’s capacity to recycle saving into investment/ consumption spending centrally helped induce collapsing total demand. A lesson of history, especially since the Second Industrial Revolution, is that an unchecked contraction in nominal spending results in depression. The destruction in living standards, massive permanent job loss, huge debt default, and other predictable welfare costs of a 21st century depression would make its 1930s predecessor look like a walk in the park. (Chapter 6) In one of its relatively minor outcomes, government debt would quickly swell by many, many trillions of dollars, saddling taxpayers with an unimaginable, unmanageable increase in liabilities. Taxpayers lose big.
The 2008-09 market free-fall in asset prices and the damage to clients’ creditworthiness quickly ate up mark-to-market bank capital. They rationally sought to reduce assets, cutting back sharply on lending and greatly aggravating the on-going collapse in total spending. In acute-instability crises, the proper policy response to such unfavorable feedback dynamics obviously includes capital injections to help mitigate the adverse effects of greatly reduced bank capital on total spending. (If the banks resist the transfers, force them to accept – which is, of course, what happened in the Great Recession.) But wait. Sheila Bair now has a different idea. No bailouts, put the banking system into bankruptcy, liquidate assets, and push investors/lenders deeper into rational inaction. Bair has been reaping the short-term political advantage that comes from exploiting the myth of taxpayer losses from big-bank “bailouts”. She either does not understand or does not care that the political expediency makes future crises much more difficult to manage.
There is a compelling alternative to the Dodd-Frank sink-all-boats approach to managing future instability crises. Switch the focus to aggressive concerted government action – on all fronts, in size and with speed – to halt and reverse the contraction in nominal demand. An explicit objective here must be to restore, especially to investor and lenders, the credibility of the trend real-side (employment/output) objective of stabilization authorities. Robust credibility banishes macro uncertainty. The strategy necessarily features rapid, large-scale actions to unfreeze financial markets. That was in a nutshell Ben Bernanke’s approach in 2008-09, and it worked. (Chapter 10) With the reversal in total spending, real activity began to improve and asset markets quickly bounced back to near pre-recession levels. (Think about that important evidence.) Banks’ mark-to-market insolvency melted away, and the TARP big-bank capital injections were repaid (as fast as Treasury officials would allow) with handsome profits to taxpayers. Effective all-in demand-management policies bailed the entire country out of an extremely bleak future that included saddling taxpayers with multiple trillions of dollars in liabilities. In comparison, TARP investments must be understood as the smallest of small potatoes. Throwing away stabilization tools (capital injections as well as other interventions that support total spending that Congress has been attacking) either out of ignorance or for political gain is unconscionable.
Blog Type: Policy/Topical Saint Joseph, Michigan