|What Would Happen If We Hadn’t Bailed Out the Banks and others?
In America today – and in the rest of the world – economic-policy centrists are being squeezed. The Economic Policy Institute reports a poll showing that Americans overwhelmingly believe that the economic policies of the past year have greatly enriched the big bankers at the expense of the public good.
Today in America, the Republican congressional caucus is just saying no: no to short-term deficit spending (that Democrats claim will put people to work), no to supporting the banking system (that world renowned economists of Harvard, Yale, Stanford, the conservative Kato Institute and Nobel laureates all claim are necessary to keep America financially and socially stable), and no to increased government oversight or ownership of financial entities. And the banks themselves are back to business-as-usual: anxious to block any financial-sector reform and trusting congressmen eager for campaign contributions to delay and disrupt the legislative process.
Nevertheless, policy over the past two and a half years has been good. A fundamental shock bigger than the one in 1929-1930 hit a financial system that was much more vulnerable to shocks than was the case back then. Despite this, unemployment will peak at around 10%, rather than at 24%, as it did in the US during the Great Depression, while nonfarm unemployment will peak at 10.5%, rather than at 30%. Nor will we have a lost decade to economic stagnation, as Japan did in the 1990’s. Admittedly, the bar is low when making this comparison. But our policymakers did clear it.
It is worth stepping back and asking: What would the world economy look like today if policymakers had acceded to the populist demand of no support to the bankers? What would the world economy look like today if Congressional Republican opposition to the Troubled Asset Relief Program (TARP) program and additional deficit spending to stimulate recovery had won the day?
TARP: Bailing out the Banks
As investment banks, lending banks, and main street banks were facing collapse, and ATM machines around the U.S. were about to be switched off, Congress and our exiting President Bush--and then our the new President Obama--created a $700 Billion bank rescue fund known as TARP: Troubled Asset Relief Program. This was massive fund was designed to give the Federal Reserve all possible room to maneuver many fixes to our failing economic systems.
Though many argue that not all banks would have ''collapsed,” no economist with a college degree was willing to say we were not about to enter a “depression.” None. Only politicians and talk show pundits railed that bank collapses would lead to a stronger America over time. Economists of the left and the right began to voice strong concern as banks began to halt issuing credit as they were suddenly faced with a far more ''real'' approximation of how much money they had in their possession that they could give out. All saw that mortgage payments began to spiral while companies cut back or went bust as they could not take loans to cover their current normal schemes of operating costs. In the long term we were faced with massively lower spending by companies and consumers, causing further economic contraction leading to a depression lasting years, similar to that of 1929. Then, in the event of a depression, there would have been a world-wide “run” on the dollar, which all economists admitted was something that did look like it could wander into the “collapse scenarios.”
The only natural historical analogy is the Great Depression itself. That is the only time when (a) a financial crisis caused a widespread, lengthy, and prolonged chain of bank failures, and (b) the government neither intervened nor passed the baton to a consortium of private banks to support the system as a whole.
Two years ago, Lehman Brothers (an investment bank) collapsed. It consequently defaulted on its short-term debt that large, generally very safe companies issue to fund their operating expenses (primarily raw materials and wages). This lead a its holdings falling to $1/share, so investors had lost money. Since this was a very rare event and investing in investment banks like Lehman Brothers, Goldman Sachs, Chase, and others had always been considered extremely safe, a huge panic ensued, causing a run at selling stocks and bonds in these large investment banks. The market for stock in these investment banks consequently dried up and there was almost no lending going on. Even banks (of all kinds and sizes) were having a hard time getting more than overnight loans (to keep them liquid for the next day’s business).
Without overnight loans, enterprises of all sorts (both financial and nonfinancial) would have likely defaulted even though they were mostly solvent. This is because even though their assets are generally greater than their liabilities, they would not have been able to come up with the cash necessary to settle the immediate claims on them (like payroll or credit for goods in retail channels, or both). So they would have been forced into default. This would have scared investors of Investment Banks even more (and again, this is generally considered a very safe market), amplifying the problems in all Investment Banks and regular banks, and so on. When the financial system is functioning smoothly, the collapse of one large bank might be manageable. But in the fall of 2008 the system was in chaos. The potential for widespread damage was heightened by the collapse of Lehman Bros., the investment-banking firm that was denied a government lifeline. The unexpected reverberations from the demise of that single, medium-sized Wall Street institution forced government officials to rethink their tough stance.
It is now 19 months after investment bank Bear Stearns failed (an investment bank that had been in operation for 132 years) and was taken over by JP MorganChase--with the assistance of up to $30 billion of Federal Reserve money on March 16, 2008, and America’s industrial production stands 14% below its peak in 2007. By contrast, 19 months after the famed private bank, “Bank of the United States,” failed on December 11, 1930, with 450,000 depositors, industrial production, according to the Federal Reserve index, was 54% below its 1929 peak.
With a complete collapse of these Investment Banks, which make money through (among other things) short-term lending to regular main street banks, all industry would have halted very quickly. Then, only a “trading shutdown” would have stopped the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.
This would have very quickly lead to an overall economic situation probably far worse than anything seen in the Great Depression. "It was clear that when Lehman Bros. went down, we were within hours of no ATM machines working any more," said GOP strategist Rich Galen. The bailout "was unfortunately necessary."
Opponents of recent economic policy rebel against the hypothesis that an absence of government intervention and support could produce an economic decline of that magnitude today. After all, modern economies are stable and stubborn things. Market systems are resilient webs that offer the best possible incentives to people to make deals and use resources productively. A 54% fall in industrial production between its 2007 peak and today is inconceivable – isn’t it?
If The Fed had let more large Investment Banks like Citibank or Wamu collapse next, it would only be a matter of time (probably not even very much time) before there would have been a run on all banks. I highly doubt even one major US bank would have survived.
So in that specific sense, I think the government interventions with investment banks (like Chase), lending banks (like Fannie Mae), and main street banks have been very successful. The whole credit system would have collapsed months ago if they had just let everything go.
Bailouts Beyond the Banks
The list of bailout recipients doesn't stop with the Banks. Some $50 billion went to try to save the auto industry through partial government takeovers of General Motors and Chrysler. In theory at least some of that money will come back to the Treasury as the companies are overhauled and continue restructuring. This money to the auto industry is really a loan, with the U.S. government holding all of these companies’ stock. GM is expected to eventually sell stock to the public again, but that could be years away.
Another $75 billion was supposed to help stop the home foreclosures that are deflating the value of mortgage-backed bonds, and deflating the value of homes. Many homeowners were walking away from their mortgages, inviting the foreclosure process, as many went unemployed and others were disgusted with the low value their homes now held with the collapse of the market (in that they were now in debt for far more than their house might ever be worth again). The money was to be used to help home-owners refinance their homes for a cheaper interest rate and longer terms. Yet, that part of the plan has done little so far to stem the tide.
As of last month, two years after the government began trying to help homeowners, some 31,000 loans had been permanently modified. There were roughly 4 million foreclosures this year alone. Another 3.5 million homeowners are seriously in default. Without real relief, another 3 million are expected to default over the next two years. Until the lending industry gets serious about its foreclosure problem, it faces continued losses for years.
As the authorization to use the TARP fund comes to an end this month, Congress is already talking about using some of the money to extend unemployment benefits. The banking industry still faces the prospect of defaults on a huge pile of commercial real estate debt that needs to be refinanced in the next few years. Federal mortgage providers Fannie Mae and Freddie Mac are still essentially broke.
Despite the political venom, the program has turned out to be far less expensive than the original $700 billion price tag.
As of Sept. 30, the government had spent $388 billion of the $700 billion TARP, and $204 billion of that has been repaid, the Treasury Department said Tuesday in a "Two-Year Retrospective" of the program. Furthermore, the government has received about $30 billion in interest, dividends and stock sales. Thus, taxpayers right now are on the hook for about $154 billion. But that doesn't include future income and gains from stocks and other assets still held by the government from aid recipients.
With these figures in mind, the White House projects that the once-awesome $700 billion program will end up costing about $50 billion, possibly less. That's down from the $66 billion the nonpartisan Congressional Budget Office estimated in August. Some administration officials suggest that in the long run, after interest payments and stock sell-offs, all the bailouts and TARP actions could even wind up earning taxpayers a small profit.
Treasury Secretary Timothy Geithner, in a cover letter to Tuesday's report, reminded Congress that the legislation had strong bipartisan support when passed. President Bush, with the support of Republicans and Democrats in Congress, started the bailout funding. President Obama took office and continued with the bailout plans. Since then, he said, "many have lost sight of the pressing need" for the program and have criticized it — wrongly, he suggested.
There are those that say that things would not have been so bad if the government had refused to implement an expansionary fiscal policy, recapitalize banks, nationalize troubled institutions, and buy financial assets in non-standard ways. The problem, though, is that all the reasons to think that depressions as deep as the Great Depression simply do not happen to market economies apply just as well to the 1930’s as they do to today.
All these collapses did indeed happen in 1930. And they could have happened again.