As I noted a few days ago, Paulson’s bailout was the worst possible way to do a bad thing. To the extent that the government had to inject money into the financial system, I explained, it would have been far better to use the “FDIC Resolution” approach, which at least addresses the moral hazard issue by wiping out shareholders and getting rid of incompetent management. Paul Volcker made the same point in yesterday’s New York Times:
The phrase “too big to fail” has entered into our everyday vocabulary. It carries the implication that really large, complex and highly interconnected financial institutions can count on public support at critical times. The sense of public outrage over seemingly unfair treatment is palpable. Beyond the emotion, the result is to provide those institutions with a competitive advantage in their financing, in their size and in their ability to take and absorb risks. …To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new “resolution authority.” Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization. To help facilitate that process, the concept of a “living will” has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts. To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.
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Like most statists and interventionists, former Treasury Secretary Henry Paulson raises the economic equivalent of monsters under the bed when justifying more government. Here’s a blurb from a story about his recent testimony on Capitol Hill:
…former Treasury Secretary Henry Paulson on Wednesday defended his decision to complete a $182 billion bailout of American International Group Inc., arguing that the unemployment rate would have risen easily to 25% without the bailout. “If the system had collapsed millions more in savings would have been lost,” said Paulson, who was Treasury Secretary at the time of the bailout, at a hearing. “Industrial companies of all size would not have been able to raise funding and they would not have been able to pay employees, this would have rippled through the economy.”
For the sake of argument, let’s assume he is right and that the economy would have collapsed without huge amounts of money being pumped into the financial system. Does that justify Paulson giving money to his friends on Wall Street? Not at all. The crowd in Washington could have used what’s known as the FDIC-resolution approach, which would have resulted in the government paying healthy financial institution to take over the insolvent ones. In effect, this is what happened during the savings & loan crisis twenty years ago. It’s not an ideal libertarian solution since tax dollars are pumped into the financial system and there is some degree of increased moral hazard since consumers/customers have less reason to monitor the safety and soundness of the banks they patronize. But the FDIC-resolution approach has one enormously good feature, at least compared to the Bush-Paulson-Obama-Geithner bailout: Bad banks are shut down, meaning that shareholders lose all their money and senior managers lose their jobs.
There was no justification for bailing out the institutions that went under water. To the extent a system-wide collapse was a real possibility, the FDIC-resolution approach would have worked. Indeed, it would have worked much better since the economy would not be plagued by the zombie banks that are only alive because of handouts from the Treasury (similar to what happened in Japan). But politicians instead chose the approach that was bad for the economy, but good for raising campaign cash and increasing the power of government.
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