Are bailouts destabilizing the global economy?

Question

I saw this posited in this WSJ opinion piece here

Notes on the Fed

• In 1998, engineering a \$3.6 billion rescue of the giant hedge fund Long-Term Capital Management.
• In 2001, slashing interest rates to reassure investors after internet stocks collapsed.
• In the 2008-09 financial crisis, backing money-market funds with up to \$50 billion, pouring more than \$425 billion into troubled banks and industrial companies, and buying more than \$1.7 trillion in government securities.
• For most of the ensuing years, keeping interest rates near rock bottom.
• In 2020, buying almost $1.5 trillion in Treasurys to help calm investors during the Covid pandemic.

A quote from the chairman of the fed before the 2007-8 financial crisis:

“We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited,” then-Fed Chairman Ben Bernanke said in a speech in May 2007, “and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

and this on our recent financial crisis:

Top officials at the Fed contended that inflation was “expected to be transitory” as late as November 2021, months after the cost of living had hit its highest rates of increase in 13 years.

and this:

“We’re not thinking about raising [interest] rates,” Fed Chair Jerome Powell said on June 10, 2020. “We’re not even thinking about thinking about raising rates.”

Notes on the History of Market Crashes

• Even as rules have proliferated and bailouts multiplied, the U.S. stock market has suffered four crashes of least 20% since the year 2000.
• The expectation that government authorities will rescue bankers and investors from their own reckless behavior may have become a self-fulfilling prophecy.
• “The attempt to control risk by lowering interest rates reduces the cost of taking risk, and so ends up increasing the aggregate amount of risk in the system,” says financial historian and investment strategist Edward Chancellor, author of “The Price of Time,” a history of interest rates.
• Faith that governments can control the madness of markets is a relatively new idea, accelerated by the creation of the Federal Reserve Board in 1913 and the Federal Deposit Insurance Corp. in 1933. Both authorities were created in the aftermath of financial crises: the Fed after the banking panic of 1907, the FDIC after the Crash of 1929 and the bank failures that followed.
• In the 19th century, investors and economists almost universally acknowledged that panics were inseparable from prosperity and an inevitable part of the business cycle.
• “It is scarcely to be expected…that a national bank can be saved from disaster by the occasional visits of an examiner,” the comptroller of the currency, John Jay Knox, wrote in his report to Congress in 1881.
• Regulation relied more on individual responsibility. Back then, if a bank failed, its officers, directors—and shareholders—would not only suffer market losses on the value of their stock. They also faced double liability, a clawback of up to the par value of their shares, contributing to the reimbursement of depositors.
• Banks still failed, of course—but not as many as you might think. Of the nation’s roughly 10,000 national banks between 1864 and 1913, 501 failed, with cumulative losses to depositors of only \$44 million, somewhat more than \$1 billion in today’s money.
  • That was less than 1% of U.S. gross domestic product, estimates Rutgers University economist Eugene White.
• In later banking crises, when modern regulators were on the case, losses were much greater: Prof. White estimates that the cost of the savings-and-loan and banking failures of the 1980s was at least 3.4% of GDP, and the losses from the 2008-09 crisis may have exceeded 7% of GDP.
• “Capitalism without failure is like religion without hell,” Berkshire Hathaway Inc. Vice Chairman Charlie Munger has said, paraphrasing the late economist Allan Meltzer.

My Take

My comments are specific to bailouts rather than regulation in general. It seems to me that the result of bailouts has lead directly to the elimination of most banks resulting in a few global giants. We just saw this play out in Credit Suise/UBS and given the current trajectory it would be difficult to convince me that isn't a ticking time bomb (particularly since the Swiss government has said as much).

If banks were allowed to, in my opinion, properly fail, they would be separated and subsequently risk amortized by distributing it across a larger number of financial entities. Thomas Sowell does a good job of mentioning in his book Basic Economics that policies should be judged on their results - not their intent. A lot of this appears intended to save the average American from hardship by constantly bailing out these banks (or at least that's what the politicians would have you believe - I realize the truth is rather more complex). However, the effect is more hardship in the long run as evidenced by the ever increasing rate of these market crashes.

Moreover, the crux of capitalism is people acting in their own best interest and if you are effectively guaranteed that the failure of your bank is unlikely to result in significant personal consequence you can, as we've seen, take outsized risks.

My take is that we should be allowing these failures to happen and individual investors can recover the FDIC limit (250k).

Answer 1

Are bailouts destabilizing the global economy?

Not necessarily. In fact in a short run they indisputably stabilize economy. That is I do not know any serious economist who would think that not bailing out banks in aftermath of 2009 Great Recession would result in more stability in global economy or make recession less worse. Similarly, you would have to search far and wide for an economist who would believe that in short term not bailing out banks would bring more stability.

When it comes to long term it is more questionable. Bailing out banks creates moral hazard. People form expectations of future, bankers are no exception. If banks expect to be bailed out after they make bad bets that will increase likelihood of risky behavior. This can lead to more banking crises than would occur otherwise (as these could occur even in absence of this). There is also strong empirical evidence for such effect, so this is sound argument (Nier & Baumman 2006).

However, there are several reason why these guarantees exist:

• a banking system that is not based on 100% reserve requirement will always be prone to collapse during panic since banks are engaged in liquidity transformation as their assets are mostly illiquid (e.g. loans they give) whereas their liabilities are typically liquid (i.e. deposits). Since in current system banks, by design do not keep reserves for all liquid liabilities they can always collapse, even if they keep conservative buffers and behave in responsible manner. One could debate merit of such monetary system, but that is off topic if we are just talking about bailouts within current system.

• banking crises can be contagious since some banks are systemically important. As a result, even a bank that was cautious and followed all best practices can fail as a result of interconnectedness of financial sector, failure of one bank can cause problem to other banks.

• Banking collapse could have serious adverse effect on the rest of the economy. In present era banks are not just institutions that channel lines of credit, but they are financial infrastructure as nowadays most transactions are done electronically via bank. As a result collapse of banking sector can nowadays create serious issues (e.g. firms that had money just deposited on regular account in a particular bank would not be able to make weekly payments to employees and might go to default due to no fault of their own). A good analogy would be asking if government should do something to prevent collapse of actual building, if the collapsing building could destroy important bridge to some city. Saving the building might encourage people not to follow correct building code but if the bridge is important it might be worth considering.

Nonetheless, nobody is so foolish as to suggest that banks should get bailout just no strings attached. Since 2009 various regulations were implemented to mitigate moral hazard. For example, there are new regulations on CEO compensation that discourage risk taking (see bis). This, is just one example, essentially most banking regulation that was passed since 2009 had an aim to force banks to be safer and discourage excess risk taking.

One can debate merits of this regulation in practice, but in theory appropriate regulation can counterbalance moral hazard issues and excessive risk taking. This is not free lunch as all the regulations have costs, most of which are eventually born by consumers, but this is simply a trade-off and what has to be sacrificed for more safety. So at least in principle it is possible to make global economy more stable by combination of bailouts, bank guarantees and appropriate regulation. Nonetheless, note as already mentioned banking crises would always occur from time to time, so all this can only make system more safe not completely prone to problems.

As whether in practice it is possible to devise correct micro and macro prudential framework that can make banking system more stable long term jury is still out, although it would be fair to say most economists believe it is possible.

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PS:

Allowing, bank failure is not the same as deposit insurance. Paying depositors above 250k FDIC limit is not the same as bank bailout. The problem with 250k limit is that it is obsolete. The argument in past was that person with 250k should have enough time and money to investigate whether bank is sound or not (whereas little guy is not able to spend time and money to do so).

However, note:

• 250k limit was set in 2006 (when it was raised from 100k to 250k for some accounts and eventually this was made permanent in 2008). That amount perhaps made sense at the time, but rising income and inflation make this limit obsolete. Especially in places such as silicon valley, where prices are so high that to live what feels a middle class lifestyle you need to earn 400k per year (according to Business Insider).

• modern banking is much more opaque and it is difficult to properly asses quality of bank even for bank regulators, so doing so for individual investor is nowadays nearly impossible.

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PSS: some of your notes/statement were incorrect:

In 2001, slashing interest rates to reassure investors after internet stocks collapsed.

Interest rates are not lowered to rescue investors at all. They are lowered because in short run lower interest rate stimulates economy, as it increases aggregate demand. Central bank's do not care about investors, they care about their mandate as they are judged not on how well investors are doing but on how well they upkeep their mandate. In US Fed has so called dual mandate, keep price stability and full employment (see Fed Richmond). The full employment mandate forces Fed to lower interest rates to stimulate output and employment during recession. This is not bailout in any meaningful way, and it does not necessary help people who made bad bets in past.

For most of the ensuing years, keeping interest rates near rock bottom.

This again has nothing to do with bailing out anybody. Fed mandate for price stability is currently being interpreted as ensuring that inflation of 2% per year on average. That is, again, Fed is in essence compelled by law to ensure inflation is around 2% on average, and lowering interest rates, ceteris paribus, leads to lower inflation.

The reason why interest rates were kept at rock bottom for so long is that during the recent decade inflation almost never exceeded 2% despite them being at rock bottom. This is one reason why Fed also did QE and pumped more money into the economy directly, these rock bottom interest rates were simply not sufficient for inflation to materialize at time.

In 2020, buying almost $1.5 trillion in Treasurys to help calm investors during the Covid pandemic.

Again this was not as much to calm investors as to increase money supply since during covid US even experienced deflation at some point.

Even as rules have proliferated and bailouts multiplied, the U.S. stock market has suffered four crashes of least 20% since the year 2000.

Most firms who are listed at various stock markets are not even banks. Stock market crashes are not directly connected to bank bailouts. For example, in 2001 stock market crash was caused by internet companies.

Stock market crash is typically defined as sudden and dramatic fall in stock prices. Stock price depends on people's expectation of what the discounted value of future cashflows (dividends, future stock price) will be. There always were, and always will be (no matter what economic system), recessions. During recessions, typically consumer spending and or private investment drops (see Romer Advanced Macroeconomics ch 5) and as a result people's expectation about future streams from these stocks drop.

To prevent stock market crashes you would need to find a way how to abolish boom and bust cycles. This is considered impossible. Even non-market economies such as USSR experience cyclical periods of economic downturn.

“The attempt to control risk by lowering interest rates reduces the cost of taking risk, and so ends up increasing the aggregate amount of risk in the system,” says financial historian and investment strategist Edward Chancellor, author of “The Price of Time,” a history of interest rates.

Again, interest rates are not lowered to reduce risk but to control monetary policy. In fact, expected interest rate changes do not even affect risk premia. To affect risk premia Fed has to raise/lower interest rates more than expected (Gospodinov & Jamali 2012) and this is byproduct rather than intention.