Two years ago, my view was this: if there is a banking crisis, the Fed should be loose with money and let the market sort out which banks deserve support and which do not. And stop there. When Bernanke let Lehman go, I remember being happy and thinking he finally had "real guts." I now view that attitude as mistaken, as I had not forecast how badly some credit markets would freeze up, most of all the collapse of repo as analyzed by Gary Gorton. Two years ago I also had not imagined that the U.S. economy could end up with so many insolvent banks at once. I had thought that the presence of "real money on the line," from bank CEOs, would stop such an outcome. That was wrong too.
Read the whole thing, which frames the issue of bailouts really well. Note that his reference in the addendum to "Arnold Kling comments" is not to what I am writing here, but to a previous blog post of mine. My response to Tyler's post is below.
Let me frame the question this way: When, if ever, should you allow the financial sector to shrink? Possible answers:
1. Never. Citigroup, Freddie, Fannie, and AIG are not dead. They're just restin'. Pinin' for the fjords. I characterize Gary Gorton this way.
2. Kill 'em all and let God sort 'em out. I characterize this as what Tyler is afraid the alternative to bailouts would have looked like.
3. Lord make me chaste, but not yet. That is, you want the financial sector to shrink at some point, but not in the middle of a crisis. I characterize Tyler this way.
4. Triage. My preferred approach, which gets some shrinkage but not the end of the world.
My preferred banking policy would have worked this way.
1. You look at the balance sheet of a bank. You allow some assets to have a range of values. The low value is the current market value of the asset. The high value is what you think that asset would be worth if the market were not in a state of panic.
2. If a bank is insolvent even assuming assets are valued at the high range, then shut it down. Go through the appropriate process (FDIC, bankruptcy, conservatorship), and deal with the consequences. My guess is the Citigroup, Freddie, Fannie, Bear, Lehman, and some others fall by the wayside under that scenario. However, my guess is that fewer than 5 of the top 20 commercial banks would have had to be closed. I assume that AIG winds up in this category, with probability .75.
3. If a bank is clearly solvent even if assets are valued at the current market value, then say so out loud. Be prepared to lend to the bank in case of panic. My guess is that between 3 and 8 of the top 20 commercial banks were in this good shape.
4. If a bank is solvent assuming assets are in the high range but not if they are in the low range, then put it under close supervision. Lend to keep it operating, but freeze its assets--no new risk taking. The bank can roll over existing loans (continue to finance businesses that it already is financing) and honor its letters of credit, but it cannot make new commercial loans. My guess is that about half of the top 20 commercial banks would have been put into this mode. Maybe AIG winds up in this category, with probability .25.
The banks under (4) might have needed a lot of loans from the central bank to deal with liquidity issues, in part because they will have assets tied up in the bankruptcies of the firms that fall under (2). That is ok. I'd rather be lending to banks that are close to solvent than bailing out banks that are clearly insolvent.
The biggest problem with my scenario is with foreign banks. Other countries do not have as many banks as we do, and my approach does not shovel as much money at them (as we did in the AIG bailout, for example). I can't promise you that my approach keeps the German financial system from collapsing, and that would not be a good thing.
I think we should not have put off shrinking our financial sector. The result of the bailouts is that we are maintaining credit markets based on false information and artificial prices. You may have pulled the airplane out of the dive, but you are flying with faulty instruments, and I don't think you are going to be happy about where you wind up.