Was it a Mistake to Save the Banks?
Since the acute phase of the financial crisis began and the decision was made to “save” the banks, the question has been asked “was this a mistake”.
Defenders of bailing out the banks like to claim there is no counter-factual on which to make this assessment since the banks were bailed out. Is this claim true?
The claim isn’t true. There is a counter-factual. There is a country that did not bail out its banking system and instead required the banks to absorb the losses on all their bad debt exposures.
What country was this? Iceland.
For the record, Iceland’s economy recovered quickly, their interest rates are at what the rest of the world would call normalized levels, and many of their bankers went to jail.
Iceland effectively proved the adage “Goldman and JP Morgan need America much more than America needs either Goldman or JP Morgan”.
Defenders of the bailouts are quick to say, but Iceland isn’t the same size as our country. The implication being size somehow makes a reliance on the banking system different.
Well, Iceland admits it borrowed from how Sweden addressed its 1990s financial crisis. And Sweden in turn admits it borrowed from the US and its handling of the banking crisis in the 1930s under FDR. This suggests the size argument is spurious.
When this defense falters, defenders of the bailouts are quick to come up with additional reasons Iceland is not a relevant counter-factual. Rather than bore the reader with these reasons, suffice it to say, the defenders are effectively engaged in throwing jello against a wall hoping desperately it will stick.
At the time the decision was made to bailout the banks, there was a knowably better choice. A choice that could still be made today.
Paul Krugman suggests as much when he observed:
So the world financial system and the world economy failed to implode. Why?
We shouldn’t give policy-makers all of the credit here. Much of what went right, or at least failed to go wrong, reflected institutional changes since the 1930s.
What institutional change could have occurred in the 1930s that made bank bailouts unnecessary? Deposit insurance was adopted.
With the advent of deposit insurance, the taxpayers effectively become the silent equity partners of any insolvent bank. All a bailout does is to make this partnership visible on terms that are favorable to the bankers and not the taxpayers.
So what was the alternative choice?
Restore transparency to the global financial system. Make the banks disclose their current exposure details.
If the banks had exposure to bad debt, market discipline would force the banks to write down this exposure. Then the question can be asked “is the bank capable of generating earnings going forward from its existing franchise”. If the answer is yes, the bank stays in business and retains 100 percent of its earnings until it has reached some regulatory threshold. If the answer is no, the bank is closed and subsequently reopened under new management.
Note, under this alternative choice, the losses are confined to the financial system. Bailing out the banks including adoption of zero interest rate policies and quantitative easing pushed the losses onto the real economy and created all sorts of additional problems.
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