The Government's Role in Financial Markets
Thank you, Claire, for the invitation, and thank you, Emily, John, Michael, Bob, and others for the comments.
Claire, you zoomed right in on the point of the book: what is the government's role in markets? How and when should it play that role? Where does the "market" end and government begin?
I'll answer your practical point. What would have happened had Washington allowed free markets to sort out the mess starting with Lehman's collapse on 9/14/08 (my wedding day, too, btw) without extraordinary government action?
Like you, I don't know what would have happened. Here is what I think.
Had the government not stepped in with TARP and other measures, the markets would have determined that the financial industry's business model of a quarter century was a catastrophic failure.
That business model was:
- a) to assume that all risk could be quantified and quarantined, thus eliminating the need for self-control when it came to borrowing against risk, and
- b) to assume that when business model a) failed, the government would step in with extraordinary aid. The government had taught financial firms, in precedent after precedent, to expect bailouts in a crisis. This expectation was built into the financial system.
In punishing failure, then, markets would have let failed banks and other financial companies die in September 2008. Those institutional deaths would have included AIG, Goldman Sachs (which would have failed in thinking that the government would bail it out of its contracts with AIG), Citigroup, Bank of America, Merrill Lynch, GE Capital (and possibly GE itself; I'm not sure how the corporate structure works there), JPMorgan Chase (whose mistake would have been to exist at all in an irrational market environment), and others. No financial institution can survive the evaporation of its overnight financing.
With financing gone, industrial companies and small businesses would have had to slash their payrolls and their orders to an even greater extent than they did. We would have more strain on the social safety net, more people out of work for months or years on end, their skills and psychological states decaying, and, in the end, an even bigger and more protracted federal stimulus to combat unacceptable social pain.
I could be wrong about this alternate reality. Maybe hours after our largest banks had failed, entrepreneurs would have created new banks, with regulators fast-tracking the process. Maybe all of the money searching for a safe haven would have gone to those new banks. I doubt it, though. Adjustment works, and is vital to free markets, but it doesn't work that quickly. One bank can fail; they all can't.
In the end, politicians who couldn't know the future determined that the risk of one unknown was just too great.
Would my scenario have been better or worse than what has actually happened? More than a year and a half after having written the book, I think it is too early to tell.
The 2008 bailouts were the right thing to do if Washington -- really, the electorate -- learns the right lesson. Government must enforce limited, predictable rules that help markets discipline themselves all the time, rather than wait until a crisis comes and offer unlimited and arbitrary support. We've got to have a way in which financial companies can fail without taking down the rest of the economy. If market participants know that won't happen, they know, too, that firms can't fail. (More on how to do this later).
The wrong lesson to learn, on the other hand, is that bailouts work. That's the lesson that the academic and technocratic class seems to have absorbed. If so, all we've bought is years of stagnation in which only implicitly guaranteed financial firms thrive. Eventually, financial firms will exploit their government support so expertly that they'll create a crisis from which we can't rescue ourselves. To see what happens when your financial industry becomes too big for bailouts, look at Ireland.
It would be better for politics to work before markets do. If Washington doesn't create an environment in which financial firms police themselves, global markets will someday police Washington, demanding (much) higher interest rates on the national debt.
Let me read through the rest of the comments on the earlier thread and respond. I will post an original thread later this evening (EST), too.
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Comments:
Jan '11
Re: The Government's Role in Financial Markets
Fantastically written - and I believe your conclusion is perfect - the bailouts were the right thing to do, assuming that government and the populus learned a lesson, and took it upon themselves to understand how we got there, and alter behaviour and expectations appropriately. What is somewhat unnerving is that people think that it should be "business as usual" now, at least in the US. Expectations have not changed.
Sep '10
Re: The Government's Role in Financial Markets
"The wrong lesson to learn, on the other hand, is that bailouts wo
Nicole thank you for your post. Unless I misread your book you imply that this is precisely the lesson that was learned each time since Continental. Why do you think it would be any different this time? Your premise is correct, but unless you have a way of changing human nature the same lesson will keep being learned until the market prevents a government bailout. I am not convinced this is not that time. Though I must admit it is beginning to look like it is not.
rk"
May '10
Re: The Government's Role in Financial Markets
Thank you for joining us on Ricochet. This was extremely informative, and nearly persuasive.
May '10
Re: The Government's Role in Financial Markets
Yes, thanks for participating.
A recessionary market free from government intervention would undoubtedly be accompanied by unpleasant financial events, but the unpleasantness of these occurrences does not lend credence to the argument for government intervention. Trips to the dentist may be marked by poignant moments of agony, but such trips are essential nonetheless. Postponing such appointments merely aggravates the inevitable misery.
Such is the case with the economy. Firms go under or go bankrupt when they fail to satisfy demand, i.e., when they are unprofitable. Firms that are unprofitable should not be allowed to remain in existence because, by implication, they are wasting scarce resources that can be used profitably by other producers and they are not satisfying their customers. Banks are not special in this respect.
Jun '10
Re: The Government's Role in Financial Markets
The US government bet against an astronomically high expected loss when it bailed out the financial markets, and to the extent they won is what we see as today's foundering and fragile economy. That said the bet the government made did nothing to alter the potential for another bailout, the cause of which goes back to the community reinvestment act. The Canadian government, more specifically Canada Mortgage and Housing Corporation (CMHC), has been guaranteeing high-ratio mortgage loans for decades and it still does do so. The difference between CMHC guarantees and the US loans was that CMHC never guaranteed 100% of the load either explicitly by assuming responsibility for bad debt or implicitly by a Fanny Mae/Freddie Mac buy up. What CMHC does is guarantee only that portion of the debt above the 75% conventional mortgage to value ratio. Thus if a loan is high ratio, say 95%, CMHC only guaranteed the 20% difference. This forces banks to make certain that their borrowers were solid credit risks. Continued…
Edited on January 15, 2011 at 2:25amJun '10
Re: The Government's Role in Financial Markets
What government guarantees do, as everyone here knows, is create a failsafe that does not properly price failure, or worse still, passes along the cost of failure to another, i.e. the government. What also goes unrecognized by most is that the presence of government in the financial system as the guarantor of last resort is that the market never hits rock bottom. What is vital about rock bottom is that it signals a re-entry point for capital. If that point is never found capital is kept out of play for the simple reason that the investor is not guaranteed that the asset he buys today will not be available to him at a lower price tomorrow. In effect this prolongs unstable and depressed markets. Continued…
Jun '10
Re: The Government's Role in Financial Markets
What is vital and to some extent proven by the CMCH example above is that the market can be used to promote social goals if there is confidence in the market’s ability to do what it does best, which in the case of banks is to determine the credit worthiness of borrowers. Banking will never work if the banker believes he will be bailed out for careless lending practice. As for protecting the market from the next bubble, it is hogwash to believe this can or even should be done. Unfortunately, one bailout may prove one too many for the sharks on Wall Street. Failure is a vital component of any market system, and it’s avoidance should not be discounted as a financial fillip.
Edited on January 15, 2011 at 3:10amRe: The Government's Role in Financial Markets
Thanks, Nicole! This is great stuff. And very illuminating.
Right after the meltdown in 2008, I was having dinner with some friends in New York. The husband is in the financial markets -- and he's a rock-ribbed conservative. His wife is in public policy, and is equally conservative. But they differed on the TARP bailouts. She thought they were atrocious and would only teach the wrong lesson to financial institutions, that bailouts will always be forthcoming, and that unmitigated risk has no downside. He told her that without federal intervention at that time, they'd be selling apples in the street.
Who do you think was right? Or are they both wrong? Or is that a risk no one had the stomach to take? And if so, as well all know, the only true corrective is financial pain -- not regulation, which can be lobbied this way or that -- then how do we inflict enough pain on those big institutions so that they feel the sting and the scar for years to come, and never have to come for a handout again?
Nov '10
Re: The Government's Role in Financial Markets
Dear Nicole,
Many thanks for your contributions here. I have downloaded your book to Kindle, and well get to it shortly.
In the meantime, I would be grateful if you could respond to the following query.
Economist Thomas Sowell has recently argued that the fundamental roots of the financial crisis were as follows: complex financial instruments ultimately depended on bets made on the U.S. housing market; so when these baseline bets went bad, the interconnected financial sector went awry; however, the main reason those bets went bad in the first place was that the government had exerted pressure over time on many lenders to make loans to the uncreditworthy--loans they would not otherwise have made.
What is your assessment of Sowell's thesis? How significant was the government's inadvertent "role" here in precipitating the crisis by pursuing the political goal of fostering home ownership? Isn't Sowell's claiming that the imprudence that led to the crisis was not merely endemic to the financial sector, nor merely facilitated by the government (e.g, by the creation of moral hazard or easy credit), but was actually imposed by the government?
Edited on January 15, 2011 at 2:41amRe: The Government's Role in Financial Markets
They could also both have been right. That's my concern about this. I appreciate that many thought the doomsday scenario was real. I don't know that they were wrong. But I can't see that we've learned the right lesson--I'd say very obviously, we have not--and I'm not sure that a society can learn that kind of lesson without somehow seeing a more immediate cause-and-effect. So if we agree that the bailouts were the right policy if the right lessons were drawn, and if we agree that the right lessons have not been drawn--does this mean, Nicole, that you've concluded the bailouts were not the right policy?
Jul '10
Re: The Government's Role in Financial Markets
Nicole Gelinas: That business model was:
I thoroughly agree with (b). On the other hand, I think we should look into how the assumption (a) and the resulting behavior came about. I am confident we will find another instance where government policy/intervention ended up distorting the markets and providing false incentives for companies to develop such an assumption.
Oct '10
Re: The Government's Role in Financial Markets
I agree with Nicole. Did you know the monetary base was only 800 billion in 2008, much of which was held abroad?
That's not a lot of money, when your talking about the failure of ~10 trillion worth of financial assets, assets that will need to be sold off. 800 billion of bank reserves and currency, to be shared amongst all those failing (and gigantic) banks? Capital markets would have totally collapsed, not simply frozen up. It would have been a gigantic mess, and the whole economy would be on hold until the bankruptcy process was over (which would take months).
Jun '10
Re: The Government's Role in Financial Markets
I'm leaning towards Cas Balicki on this. Failure is a necessary function in the capitalist system. At times that means even catastrophic failure. I read that if AIG had failed, every airline in the country would have been grounded for lack of insurance. No one asked the question "but for how long?" Seems to me that someone like Warren Buffet would have jumped at the chance to expand his business. I will trust the corrective mechanisms inherent in markets before I trust government intervention. A short, sharp shock is preferable to lingering pain.