Arnold Kling  

The Bailouts and the Economy

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Cato and the Kochs, Take 3... Downton Abbey...

A Panel of Expert Economists was asked whether they agreed with:


Because the U.S. Treasury bailed out and backstopped banks (by injecting equity into them in late 2008, and later committing to provide public capital to any banks that failed the stress tests and could not raise private capital), the U.S. unemployment rate was lower at the end of 2010 than it would have been without these measures.

The vast majority either agreed or strongly agreed. None disagreed.

One expert cited this paper as providing support. Another expert cited Friedman and Schwartz, and "a Central Banker who'd read it and had the courage to act on it."

Interestingly, nobody said, "This is a really difficult and important question. We should do the best we can to come up with an answer." (Maury Obstfeld comes the closest.)

Also, nobody gave what I think of as the Scott Sumner answer, "We used to believe that employment depended entirely on the path of NGDP relative to trend. We used to believe that this path could be controlled by the monetary authorities, regardless of what is going on with individual banks. I have not changed my beliefs, even if everyone else has." (Those are my words. Scott, feel free to correct me if I am misrepresenting your views. [update: Scott says that he would take out the word "entirely" but otherwise likes the post])

The fact that mainstream economists regard the question as settled is what leads me to expect a lot of research into how a financial crisis and de-leveraging cause macroeconomic distress. It's not in the textbooks. Anyone can do handwaving. We've seen some papers come out in the the last few years. I expect to see many more.


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COMMENTS (10 to date)
AJ writes:

Wow, I am amazed at the consensus. I believe this explains the Bernanke actions if this is the mindset of the ruling cabal of economists today.

Letting banks fail would have been a good thing. Cleaning out financial assets is a good thing. Capitalism needs this about every ten years. Resulting recessions are brief if originated by asset collapse or business failures. Economic activity resumes and the means, asset, and knowledge of economic activity continues. The worst financial collapse in my knowledge was 1873-1874. Over half of U.S. private businesses and banks insolvent and defaulting. Yet a full recovery in a year.

With capitalism, recessions and asset price collapses are inevitable (if difficult to predict); but for depression and sustained recession and slow growth, you need government intervention.

AJ

joeftansey writes:

Until we get some falsifiable hypotheses in economics it's simply going to be whoever can tell the best story or who has the fanciest mathematical model.

ZERO quality control on economics... Someone needs to build the case that we should stop paying attention to macro.

DPG writes:

I like Pete Klenow's answer best.

The apparent consensus is that financial institutions should be saved from bankruptcy because of the danger of a credit crunch.

Does anyone have suggested readings on insolvent banks? Is it impossible to have an orderly unwind of a bank? I'm serious; I would appreciate pointers to the literature on this topic.

I look at the crisis and I wonder about the counterfactual. Doesn't the FDIC exist to backstop commercial banks? Many of the large failures were investment banks, and many of them seemed to muddle through on their own. Several banks went under and were bought out by competitors. Goldman went to Buffett for cash; Morgan Stanley went to Mitsubishi for cash.

TARP did not prevent a severe credit crunch. The status quo has to argue that the credit crunch would have been even worse -- catastrophic -- in the counterfactual. That's why I'm interested in the literature. Did the Fed really need to target specific banks and asset classes? Can we say with certainty that the financial system would have collapsed? Could we have muddled through with an accomodative monetary policy? Could a phoenix, capitalized by the PBOC and ADIA, have risen from the ashes of a financial system that was allowed to fail?

Tom West writes:

Can we say with certainty that the financial system would have collapsed?

No, but there's enough uncertainty that most economists can say "the financial system might have collapsed".

And that is probably responsible for the consensus. It's the 1-5-10-20-50% chance of an unemployment rate north of 50% that probably motivates their agreement with the original statement.

JeffM writes:

Very interesting post and comments. I hardly know where to begin.

Let's postpone for the moment whether we should have a central bank. The classic purpose of a central bank is to act as a lender of last resort to banks (and perhaps insurers) that have "creditworthy" assets to use as collateral. In a comment to a previous post, I tried to distinguish between "creditworthy" and "liquid" assets. The questions that seem relevant to me about what happened in 2008 are (1) did the central bank limits its lending to what was secured by arguably creditworthy assets, and (2) if it was reasonably necessary for the central bank to lend to probably insolvent institutions that were probably "too big to fail," did it do so in a way that minimizes moral hazard.

I believe the answer to that last question is a clearcut "No." The precedent that should have been used was Continental Illinois. The shareholders were effectively wiped out, and senior management was immediately removed. TARP et al. was totally misconceived and deserves the pejorative of "bailout." (I except the banks, of which there were many, that were strongarmed into participating in TARP when they did not need to.)

Notice that this argument does not require an assertion that central bank intervention was unwarranted. It involves an assertion that the intervention was badly designed and executed when a superior alternative was available within living memory. (Arguably even the RTC represents a precedent for superior intervention although I am not sure I'd like to argue that case.)

All I want to say about an argument based on what percentage of banks, units that are not comensurate in any meaningful sense, failed is that what is relevant is what was the aggregate percentage loss on bank liabilities.

I'd like to argue that Popperianism is simply not relevant to economics, but clearly I cannot do that in a blog comment. All I'll say is that I am not too impressed with the empirical support for either microeconomics or macroeconomics. Go to any company and see whether they set prices by equating marginal revenue and marginal cost. They seldom know either so equating them is almost always impossible.

Because this is just a comment, I am going to make one of those handwaving arguments disparaged in the main post. One of the fundamental clarifications in macroeconomics is Mill's essay on gluts: there can never be a general glut of everything, but there can be an undersupply of money relative to the supply of goods. Wiping out say 30% of the money supply of the US overnight by letting BOA, Citicorp, JP Morgan Chase, and maybe Wells fail is an experiment that I'd not like to venture. Macroeconomics may not be very well validated empirically, but I'd argue that the evidence for such rapid and substantial reductions in the money supply being benign is pretty slim.

That leaves the argument about whether targeting the biggest financial institutions, whether they needed support or not, was sensible. I'd argue that it probably was necessary to rescue those that were failing but were too big to fail, e.g. Citi, to minimize the risk of a much worse recession than what occurred. The basic element of that argument is that even if the losses incurred in the aggregate were eventually fairly small and the central bank flooded the solvent banks with reserves while the losses were being sorted out, lending relationships can take significant time to be reconfigured, particularly during a recession.

The lesson to be learned for the future, in my opinion, is not to throw Mill, Bagehot, et al. out the window, but to recognize that institutions that are arguably too big to fail are too big to exist. Their existence invariably will eventually force the central bank to reward imprudence.

I apologize for making handwaving arguments, but blog posting does not really permit much more.

Dave writes:

That would be a good question to know the answer to, but it would have to be followed with: Should the unemployment rate at the end of 2010 have been the goal of those policy decisions?

To which the answer, in my opinion, is a clear "no."

Floccina writes:

They did TARP because of the fear of feedback that would have very bad effects, perhaps we can skip all that and work on remaking the system so that feedback is eliminated and does not depend on having the right people at the central bank.

We should also look for a cheaper way to address unemployment (i.e. a wage subsidy) rather than TARP and fiscal stimulus which seem ridiculously expensive to me.

Scott Sumner writes:

Good post. Those are pretty close to my views, although I'd remove the term 'entirely.'

There will be lots of papers on why banking crises cause unemployment, even though no one has produced a shred of evidence that the high unemployment isn't due to the biggest fall in NGDP since 1938, and no one has produced a shred of evidence that the Fed couldn't have prevented this crash with 5% NGDP targeting, level targeting.

Tom West writes:

we can skip all that and work on remaking the system so that feedback is eliminated

I suspect that would require eliminating humanity. When things crunch unexpectedly quickly and badly, history is replete with examples of human beings panicking and turning a bad situation into a catastrophic one.

Charles R. Williams writes:

TARP was one piece of a disastrous multiyear policy vis-a-vis the financial sector. Pull out that one piece leaving the rest in place and things would have been worse. If you operate on the philosophy that certain banks are too big to fail, then you must not allow big banks to fail. If you, through regulation, create a uniform but unstable pattern of banking across the financial sector, then the TBTF banks can all fail simultaneously.

Also, there were better alternatives to TARP, but the question doesn't allow the consideration of alternatives.

Sumner is right to emphasize the recession as the precipitating factor behind the financial crisis, it doesn't follow that macro-economic policy in 2007-2008 either caused or could have prevented the recession. Even if the banking sector had been sound in 2007-2008, we still would be dealing with 9% unemployment today and there is no macro-economic policy that can improve that number.

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