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.
“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 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).