We Should Have Let The ‘Too Big’ Fail in 2008
Allowing drunken credit binges, followed by hangovers ameliorated by liquidity, is now a recipe for disaster.
Wildfires in the American west have been getting worse. While global warming may play a role in this problem, it is well known that American forest management practices have contributed significantly to this problem. By the nature of the area, forests in the American west have been subject to regular forest fires. The effect of these fires was generally to clear out a lot of dead-plant material and weaker trees. These regularly occurring fires actually make healthy trees in the area more fire-resistant; by experiencing episodic stresses, the forest becomes antifragile in the face of fire.
Yet forest-management practice over the last century or so has often worked to defeat this evolution of natural resilience in forests. All too frequently, an effort has been made to stop all forest fires as soon as possible. But this simply allows the accumulation of more and more combustible material, so that when finally, despite all efforts to suppress them, a significant fire does break out, it has lots more fuel to feed it… and thus our many recent megafires.
A market economy is not a forest, yet as complex, adaptive systems, they share many features. Fires in a forest play a similar part to downturns in an economy: both help to keep the amount of deadwood and unhealthy inhabitants from getting out of hand. When business confidence is at its flood tide, marginal business ventures are launched, and kept afloat by injections of credit. But many of these enterprises are unsound, and consume resources that would better be allocated elsewhere. When business sentiment ebbs, these vessels run aground, and the resources they had commandeered are released to be used in more beneficial ways.
But as in our forest-policy example, our economic policy has too often been directed at preventing these corrective events from exercising their purgative effect. Ever since the creation of the Federal Reserve, policy has been directed at stamping out any economic fires as soon as they start to burn. The hope has been that the economy can continue “to infinity and beyond,” without having to suffer through downturns. This aim was famously expressed, just before the 1929 stock market crash that marked the start of the Great Depression, by the prominent economist Irving Fisher who expressed the opinion that stocks had reached “a permanently high plateau.”
At the beginning of this century, the American economy saw the dot-com boom-and-bust. The dizzying ascent of tech stocks at that time, followed by their nauseating descent, can plausibly be attributed to actions by the Federal Reserve during the 1990s.
To ease the pain of credit withdrawal at that time, the Fed again adopted easy-money policies. This led to the real estate bubble of the mid-aughts, and the “Great Recession” of 2007-2009. This time, the amount of money pumped into saving financial institutions may have been as high as $29 trillion. Yes, that’s trillions, not billions.
The Great Recession and its wake caused enormous bank consolidation, as hundreds of local banks closed in the wake of the collapsed real estate bubble. The ten largest U.S. banks came to hold about half of all deposits. The bailouts were supposedly necessary because many financial institutions were deemed “too big to fail”: but instead of being broken up, the giant financial institutions only became larger.
Pundits confidently announced that banks are “stronger now” after the Great Recession—until they suddenly need to be bailed out again. One may protest, “But who could have foreseen a global pandemic?” Except that many did foresee one.
For instance, Bill Gates has been warning of pandemic risk for many years. Nassim Taleb warned about the inevitability of a viral pandemic due to increased globalization as long ago as 2007, and has called the current crisis a “white swan”: completely predictable. Prudent companies ought to have been insuring themselves against such a risk. But far too many saw good times as a chance to throw caution to the wind and drive up their stock price through leverage. Thus, as Taleb puts it, current policy is “a bailout for investors and for companies that drained cash or levered up to buy back stock.”
Furthermore, it is notable that these bailouts repeatedly favor the interests of the wealthy, at the expense of the multitude less well off. The Great Recession bailouts could have been directed towards homeowners, instead of towards banks. The bankers got bailed out, and got to seize the homes of those to whom they had sold overly expensive mortgages. Minority homeowners were especially hard hit.
While I don’t wish to minimize the moral problem with rescuing the imprudent rich while letting the prudent (and the less-well-off) foot the bill, there is perhaps an even greater downside to our continued bailouts. Our economic system as a whole “learns” a very bad lesson: saving, insuring against risk, and expanding cautiously are for “suckers,” as the system rewards those who make huge profits by taking extreme risks during good times, and bailing them out when those risks blow up on them. Of course, a healthy society needs some risk takers if it is not to stagnate. But that only works if those risk takers bear the consequences of the risks they take themselves. If every time those risks go badly, resources are taken from the more cautious to bail out the adventurers, then being cautious becomes a fool’s game—and irresponsible risk taking becomes the way to get ahead.
But now that we are in this cycle of drunken binges on credit, followed by hangovers that must be ameliorated by further injections of liquidity, how can we escape? It is true, given the fix we have gotten ourselves into, that the failure of, say, JP Morgan Chase, Goldman Sachs, or AIG, might genuinely threaten the economy as a whole. So, like an alcoholic withdrawing from the bottle, it might be dangerous for us to “go cold turkey.” Nevertheless, we can try to wean the alcoholic off the sauce even while we provide enough juice to stave off the worst withdrawal symptoms.
One possibility is to make every bailout conditional on reform. Probably the first thing that should happen in a company—before kneeling before the government with its hands outstretched for bailout funds—is that the CEO should agree to step down. They have mismanaged the company, failed to deal properly with risk, and left the company without a reserve to get through an emergency. Furthermore, companies that appear “too big to fail” in one crisis should, if bailed out, be broken up so that their possible failure no longer presents such systematic risk. Yet another salutary move might be to make top executives, as a condition for a bailout, pay back bonuses they had received from taking on too much leverage.
These ideas may seem quite radical. But when the alternative is to keep taking more and more money from those who did not assume extreme risks when times were good—and handing it over to those who got paid multi-million dollar bonuses for taking them—these proposals might seem a little less far out.
Gene Callahan is the author of Economics for Real People and Oakeshott on Rome and America. He has taught philosophy, economics, mathematics, and computer science at the university level, and holds a PhD in politics from Cardiff University.