Why TARP Was Good, and Why Bailout Guarantees Are Necessary

The CBO has once again lowered its estimate of the cost to taxpayers of TARP. It's not down to $25bn, from an expected $109bn in March. At this rate, the program might make a profit overall, rather than just a profit from the bank portion of the program. Even if it loses $25bn, it's hard to argue that that's poor value for money, as Ezra Klein and Jon Chait point out.

Ryan Avent is not convinced. He says that the success or failure of TARP cannot be measured solely in dollars, but also in how it reshaped the political economy of finance in a way that exposes taxpayers to future defaults:

But to cite the dollar cost of the bill and declare it a roaring success is to totally misunderstand what TARP actually did. ...

What's important to realise is that built into the rise in value of the companies backed by the government (the banks especially) is the government's guarantee against failure. The government hasn't yet withdrawn this guarantee, and so it's still on the hook. President Obama could go before the country and say, "Ok, having sold our shares we now promise to never again bail out troubled companies". Markets would go "Ha ha ha", and continue behaving as if the government was still on the hook. Because it is. ...

But having convinced markets that the banks won't be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. ...

So what has TARP cost American taxpayers? The correct answer is: we don't know. It's almost certainly less than the cost of the Depression that would have resulted from cascading failures at the nation's largest banks. But it's a lot more than $25 billion.

I think this is exactly wrong. The first wrong thing is thinking that a bailout guarantee didn't exist before the crisis. It did. The pattern of U.S. government intervention into financial markets, from the Latin American crisis (using the IMF) to LTCM, always suggested that the government would step into to prevent financial collapse. This was the Geithner plan, forged from his experiences in the Tequila and Asian crises. The Bear Stearns deal in March, 2008 reinforced that pattern. The exception was Lehman, and that's why the Lehman collapse was so devastating: markets expected the government to intervene when necessary. When it didn't, it set off a major panic. That is not something we should be keen to replicate.

The second wrong thing is to think that this is bad. As I wrote some while ago:

At some point in the future some financial institutions will become illiquid. If the government makes a credible commitment to not provide funds to those distressed institutions, then the first sign of trouble will touch off a run on those firms. Bank runs are contagious, so even if only a single firm is affected initially, the trouble could sink the whole system. It's much better for the government to instill confidence in the system by guaranteeing that they will support illiquid firms than to guarantee that they won't.

And:

How do escape the vicious cycle of bank runs? The government intervenes by guaranteeing the funds of depositors. This intervention may be costly, but is much less costly than continuing to let a panic eat the financial system from the inside out. Nevermind the fact that the government cannot make a credible commitment to not bailout systemically-important financial institutions: it would be a bad thing if they could! Such a commitment would lessen confidence in the financial system and thus make runs more likely, not less.

Of course there are concerns about moral hazard, but there are ways to address these without pretending the U.S. government can make a commitment to not bail out financial firms when everyone knows they will if things get bad enough. For example, the government can protect counterparties and depositors while still punishing bank management and shareholders.

In fact, some governments choose to do this. Guillermo Rosas wrote a very good paper (pdf) in 2006 describing why some governments opt for bailouts, while others follow Bagehot's advice to shutdown illiquid firms. Rosas also has a book on the same topic, which I've not yet read.

The point is that we can make the punitive cost of intervention severe enough for bankers to restrict moral hazard, while still working to maintain confidence in markets and prevent runs. This is what we should do. (Note that my view has shifted on this over time; at the height of the crisis I was unconvinced that punitive damages were a good idea, but now I think they are. For management and shareholders at least.)

Avent argues that TARP cheerleading is damaging because moral hazard prices in that we will bail out distressed firms automatically in the future. I worry about the opposite: that the TARP slagging (by progressives and Tea Party types alike) weakens confidence in markets and makes the system more susceptible to damaging bank runs. Perversely, this could make public intervention more likely rather than less. To see an example of this in real time, look at the tepid commitment from the EU to support the PIIGS. If they had made a bigger commitment at an earlier date, the overall cost of intervention would likely have been much lower.

In other words, we don't want the political equilibrium to shift further away from engaging in emergency actions to stabilize teetering markets. That's the world of the 1930s. If we can make a commitment to maintain stability in financial markets (thus benefiting the country at large) without rewarding financial managers and shareholders for profligacy (thus hurting those that took excessive risks without harming innocent bystanders), then we definitely should. I'm not saying that we did that effectively in this crisis, but that should be the goal.

So here's the story we should be telling: TARP was an exceptionally successful program. The best thing about it was that it stabilized markets at relatively low cost, and perhaps even a profit. The worst thing about it was that it was not severe enough towards management and shareholders. But we can fix that the next time this happens. We can pass legislation today that if financial firms require government bailouts, they come with harsh penalties. We should not throw out the good with the bad, and we don't have to. We should always insist that we will do whatever is necessary to maintain confidence in markets, but in so doing we will try very hard not to reward those that make bad investment decisions. They should be forced to bear the cost of their actions.

I'm not sure if there's a winning political coalition for that perspective right now. The financial industry obviously wouldn't appreciate that sort of commitment. Neither would most progressives, libertarians, or Tea Party conservatives. But that's that the narrative we should present.

When An E.U. Bailout Is A U.S. Bailout

Yesterday I posted about how the Fed has been acting as the world's central bank, and how those of us who learned from Kindleberger view this as a very good thing. But it's not just the Fed, as the other parts of the U.S. are ready and willing to step in and provide funding for Europe via the IMF:

The United States would be ready to support the extension of the European Financial Stability Facility via an extra commitment of money from the International Monetary Fund, a U.S. official told Reuters on Wednesday. ...

The remarks foreshadow a visit to Europe this week by a U.S. Treasury envoy who is expected to visit Berlin, Madrid and Paris to hold talks on the ramifications of the debt crisis. ...

The developments have echoes of the pressure applied by Washington on European capitals last May to create the near $1 trillion EFSF safety net that was last week used to rescue Ireland after its banking crisis spiraled out of control.

Given what we know about how the U.S. uses the IMF for strategic purposes, we should think of this as primarily directed at protecting the American financial sector. Just as the European Emergency Financial Stabilization Fund is primarily intended to protect the German and French banking sectors. That is, large European financial firms are heavily exposed to southern European debt, and are also counterparties of large American banks. Remember that U.S. are exposed to European banks to the tune of $3.5 trillion. If debt defaults harm European banks, this could undermine financial stability in the U.S. as well. Given that EU regulators are requiring another round of stress tests for European banks, the solvency of the European banking system is still very much in doubt. For that matter, the U.S. banking system is still quite weak.

In other words, the E.U. sovereign debt crisis is starting to resemble the Latin American sovereign debt crisis in some important ways. The response of the U.S. to both is to mobilize the IMF to shore up the system with emergency funding to the counterparties of American banks, and turn to the Basel Committee to push the costs of stricter regulatory regime onto other states. We've seen this movie before (pdf).

I've noticed some howls of complaint about this (from Facebook friends, for instance, although I'm sure it will percolate into the punditocracy soon enough). The argument goes: "How can we afford to bail out Europe, when we can't afford to take care of ourselves?" The answer is twofold: First, we can't afford not to work for financial stability around the globe. The costs of doing nothing are likely much higher than any bailout costs. If the U.S. abandons the rest of the world, the result would be disaster and chaos. Second, as I said above, U.S. actions are about the U.S., not Europe. It's not even about preserving the monetary union, or happy-go-lucky feelings that come from European integration.

A proper view includes many more dynamics than just money going from the U.S. to the E.U.

IR Cartooned

Large image here. Via Evgeny Morozov's Twitter, via Dan Drezner's Twitter.

Rosling on the Beeb

We've featured Hans Rosling and his cool data visualizations on this blog multiple times. Now he's got his own BBC show, "The Joy of Stats", which airs on December 7th on BBC4. Unfortunately, it does not appear that it will be shown outside the UK, but here is the preview:



(ht: The Economist Daily Charts blog)

Explaining Ireland

I really can't recommend this guest post at Crooked Timber enough. I don't want to excerpt it and dissuade anyone from reading the whole thing. So read the whole thing.

The author, Niamh Hardiman of University College, Dublin, also has an SSRN working paper on the Ireland crisis. I haven't finished it yet, but it is also very good so far.

The best blog I know of concerning the Irish economy is, er, The Irish Economy.

UPDATE: This article by Kevin O'Rourke is also excellent.

Hegemony and Bank Bailouts

Back in October I argued that Ben Bernanke, as a scholar of the Great Depression, may have emphasized the global economy over the domestic economy since 2008. In other words, perhaps he had not followed the advice of Sumner, Williamson, and others to engage in quantitative easing on a massive scale because he did not want to encourage competitive devaluations. As I wrote then:

Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. ...

I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets. ...

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Now we see that the Fed's global actions have not been limited to refusing to engage in competitive devaluations. The Fed also provided emergency funding to many of the world's largest banks:

Foreign banks were among the biggest beneficiaries of the $3,300bn in emergency credit provided by the Federal Reserve during the crisis, according to new data on the extraordinary efforts of the US authorities to save the global financial system.

The revelation of the scale of overseas lenders’ borrowing underlines the global nature of the turmoil and the crucial role of the Fed as the lender of last resort for the world’s banking sector. ...

The biggest cumulative borrower from the Term Auction Facility was Barclays, which bought the US operations of Lehman Brothers out of bankruptcy in September 2008.

Barclays borrowed a cumulative $232bn from the TAF through various subsidiaries. ...

Bank of Scotland and RBS of the UK, Société Générale of France, Dresdner Bank and Bayerische Landesbank of Germany, and Dexia of Belgium were all among the top 10 users of TAF. The second-largest user was Bank of America, which bought Merrill Lynch during the crisis, and borrowed a cumulative $212bn. The biggest seller of commercial paper to the Fed’s Commercial Paper Funding Facility, which bought illiquid short-term loans, was UBS of Switzerland, then insurer AIG. Five of the top 10 CPFF users were European banks.

This is a major revelation, indicating that the U.S. government was prepared to secure the stability of financial firms regardless of national origin. This provides further evidence that the Fed's behavior cannot be understand out of a global context. If you are a follower of Kindleberger, as I am, you have to think of the Fed's actions as a very good thing. So of course the domestic politics of this are going to be ugly, stupid, nativist, and parochial. In other words, the recent political chatter over whether the Fed should have a single mandate or a dual mandate is misguided. Regardless of the domestic de jure mandate, the Fed has a de facto global mandate. It needs to be able to fulfill it, or else we risk a return to the 1930s.

The Political Economy of Climate Change

Or, why hoping for an international agreement in Cancun or elsewhere is senseless:

In one paper Professor Kevin Anderson, Director of the Tyndall Centre for Climate Change Research, said the only way to reduce global emissions enough, while allowing the poor nations to continue to grow, is to halt economic growth in the rich world over the next twenty years.

This would mean a drastic change in lifestyles for many people in countries like Britain as everyone will have to buy less ‘carbon intensive’ goods and services such as long haul flights and fuel hungry cars. ...

He said politicians should consider a rationing system similar to the one introduced during the last “time of crisis” in the 1930s and 40s. ...

“The Second World War and the concept of rationing is something we need to seriously consider if we are to address the scale of the problem we face,” he said.

There is no country that is willing to do this. Not one. Not if doing it would prevent climate change from occurring. Not if every other country was doing it too. We have had no economic growth in the past two years, more or less, and the political fallout has been enormous. Imagine the reward given to the politician that advocated forfeiting the next two decades of growth?

In two old posts I did some back-of-the-envelope calculations of how much economic well-being we'd be giving up in order to follow scientists' recommendations to combat climate change. Under one scenario, in which we sacrifice 1% of GDP growth (not total GDP) from now until 2100, our 2100 standard of living would be more than halved. Of course, that's just the medium run. As I wrote in one of those posts:

In other words, the cost of stopping climate change is infinitely high if your time horizon is long enough, but is extraordinarily large even in the short run.

The point is that sacrificing 20 years of economic growth is a very high price to pay. Economic growth is not just dollars and cents, but also technological progress that those dollars and cents make possible. Think back to 1990: no laptops, PCs were prohibitively expensive, the internet was slow, no smart phones, no HDTV, no iTunes, no sushi restaurants (except in NY and LA), etc. Fill in the blanks.

It will be impossible to convince people that it is worth it. One reason for that, as I mentioned in the posts above, is that economically it probably isn't worth it. In other words, the economic costs of dealing with climate change when it occurs is likely less than the economic costs of trying to prevent it. But even if that weren't the case, the international dimension of this is daunting. British (or American or French or German) voters will be even less willing to sacrifice two decades of growth so that other countries (China and India and Brazil) can continue to grow. Developing countries are already accused of "stealing our jobs" and other such; imagine the fate of the politician who began a stump speech with "You thought China was taking your jobs before, well I say we amplify that process as much as we can. Back to WWII-style austerity!" It's impossible to imagine a political equilibrium which limits MDC growth for the benefit of LDC growth.

The politics of climate change are as abysmal as the economics.

(Link via KPC)