Since Paulson, Geithner and Bernanke decided to save the banks at all costs, it has been clear the economic costs would be significant.  They are, but they pale in comparison to the political and social costs.

Gautam Mukunda observed

In my opinion, the way that the Bush and Obama administrations chose to respond to the crisis greatly exacerbated the change in American political culture produced by the crisis.

Fundamentally, the American (and world) economy was crippled by the actions of the leaders of the American financial sector, and the U.S. government chose to “punish” those leaders by giving them enormous sums of money through bailouts.

This may have been the right decision. It may have been necessary to prevent a second Great Depression. It might even have been economically optimal, in the sense that it prevented an even worse outcome at the lowest possible cost…

Regular readers know bailing out the banks is never the right decision.   They also know the narrative about preventing a second Great Depression used to justify the bailouts was a lie.

There was no reason to think in response to the Great Depression policymakers didn’t take the necessary steps to prevent another depression from happening.  In fact policymakers did take these steps.  They introduced automatic stabilizer programs to protect individuals.  They adopted deposit insurance to protect the real economy.   The existence of deposit insurance meant banks could absorb all the losses in the financial system.  Bankers could be held responsible.  Deposit insurance also lets the insolvent banks continue in operation to support the real economy until such time as the regulators chose to close them.

It isn’t surprising the Great Depression policymakers put in place everything needed for the economically optimal lowest possible cost response to a financial crisis.

It nonetheless strikes most Americans as fundamentally unjust.

Justice is generally conceived of in one of two ways. The first, and more common, one is that justice is fairness. In a fair world, good behavior is rewarded and bad acts (usually meaning acts that contravene generally accepted norms) are punished….

The arguments in favor of the government’s response to the financial crisis — ranging from TARP, to the nationalization of AIG, to allowing bailed-out banks to continue to pay bonuses to their employees — all hinged on the logic of justice as the rescue of the American economy at the lowest possible financial cost. These arguments, however, entirely ignore the powerful and far more common belief that justice is fairness….

If you were a player in the American financial system, the government did everything possible to make sure that you did not suffer consequences from the crash your industry had caused….

There was plenty of evidence to support the notion the policy response was unfair.  The government kept bankers out of jail despite all their misbehavior including rigging the financial markets.  At the same time, the government forced the real economy, taxpayers and debtors to shoulder the cost of the crisis.  This included 9+ million foreclosures.

In short, the Committee to Save the Banks under both the Bush and Obama administrations created a new world order where good behavior was punished and bad behavior was rewarded.

Even if we accept the argument that focusing almost entirely on the health of the financial sector was the best way to handle the crisis, this approach creates a series of problems. It largely removes any pressure on the sector to permanently change the behaviors that led to the crisis. Even worse, though, it corroded the bonds of trust required for the functioning of democracy.

It’s entirely reasonable that many voters would lose trust in the governing elite. And when that trust is broken, democratic populations will turn to politicians who promise to overturn that elite…

Trust.

The story of the Great Financial Crisis and the policy responses to it is the story of the complete breakdown in trust.  After all, the Committee to Save the Banks didn’t trust investors with the truth about the banks.  Nowhere is this lack of trust more clearly shown than the stress tests.  Why is the US government offering an opinion about the solvency of the banks when by requiring the banks to disclose their current exposure details the market could determine bank solvency for itself?  Could it be the US government doesn’t want the market to find out the banks are insolvent?

A breakdown in trust was not confined to the financial markets.  Once the government went all in supporting the banks, the breakdown in trust spread to the government too.

Since before the acute phase of the crisis occurred, I have been saying the breakdown in trust could be avoided and even now reversed.  The key to doing so is the restoration of transparency.

Why?

People instinctively want to trust, but trust really exists only when people know they can also verify.

It has been well known since Justice Brandeis that sunlight is the best disinfectant.  The way you change the behavior of the bankers is by bringing transparency to the firms they work for and the securities they sell.