Imagine a group of children playing near the edge of a tall cliff. One isn’t cautious enough to watch where he’s running, and darts toward the edge. The supervising adult can a) rescue the child, assuring him that he will always be safe, or b) let the child fall to his death as a warning to the others. Rescue the child, and none of the children will learn caution. Let the child fall, and the adult is responsible for a tragic death.
Fortunately, there is a middle ground: save the child, but instill a fear of the cliff. It might seem a strange metaphor, but it applies fairly well to a simple view of macroeconomic crisis recovery.
Two main schools of thought address crisis recovery.
The first approach, developed by John Maynard Keynes, suggests that in times of economic crisis, the government should save the day. The logic is: if steps can be taken to avoid a financial disaster, they should be taken. The government should spend so as to increase GDP, and encourage others to spend as well (interestingly, this can be financially savvy for governments since, when a crisis hits, the biggest loss to the government is not stimulus spending, but rather lost tax revenue. In the short term, at least, it can make sense for a country to spend its way out of a crisis).
The second approach, developed by F.A. Hayek, encourages natural selection: if banks that took excessive risk were allowed to fail, soon we would see a more risk-averse and thus more stable banking industry. The logic is that one bad bust will prevent (or limit) the next one. This approach is elegant in its efficiency, but is analogous to letting the child fall off the cliff.
In the 2008 financial crisis, the US took a Keynesian approach, bailing out banks and other critical corporations.
Not every firm that received government loans was responsible for the financial collapse. Some simply needed cash to ride out the storm, since even healthy institutions can take hits during a panic. Stable firms such as Goldman Sachs actually aided market confidence and recovery by taking loans that they didn’t need: when people saw the stable institutions receiving the same loans as the less stable ones, they were less inclined to panic than if only a few companies had been singled out.
There’s a wealth of evidence to suggest that these loans worked. It’s always difficult to answer with confidence when dealing in counterfactuals, but according to many economic indicators, the decisive action by the Fed and Treasury Department kept the recession from becoming a depression.
Yet according to Hayek, preventing a depression wasn’t entirely a good thing. With the costs of risk-taking nationalized, banks had no need to learn the consequences of risk. In Hayek’s view, the bailout places the government in the role of Holden Caulfield, turning children away from the cliff’s edge without interrupting their death-defying play.
AIG illustrates perfectly how the bailout de-incentivized learning the costs of risk.
AIG insured a huge number of mortgage-backed securities at a very cheap rate. They thought that these securities were safe, and that insuring them would be easy money. So they insured as many as they could. In fact, they insured well beyond their ability to actually pay out in the event that housing prices would cease to climb (and the ensuing decline in prices made their position even worse).
The consequences of the fallout from AIG’s recklessness and incompetence spread to other firms. Yet few impositions were placed on AIG after the US intervened. For example, Treasury Secretary Paulson allowed AIG to give out retention bonuses soon after receiving their capital injection.
It seems backwards: these people shouldn’t have needed money to keep them at their jobs. Instead, other firms should have been afraid to hire the people being induced to remain, and if management was afraid that many would retire en masse, a bonus isn’t a long-term solution. Paulson wanted as many firms as possible to enter into his bailout plan so as to stabilize the economy quickly, but AIG wasn’t in a position to negotiate limits on compensation.
In fairness, both Paulson and Bernanke were working under incredibly high-paced and stressful conditions. They achieved unprecedented action in record time, somehow forcing cooperation from Congress and from two opposing presidential candidates as they did so.
Unfortunately, the long-term results of their actions cannot be ignored. They forced far too little punishment on those whose incredible lack of due diligence brought about the recession. Steps toward the middle ground – saving, but not without consequences – could and should have been taken. Save the child, but instill a fear of the cliff.
On the lighter end, this could have meant harsher limits on compensation. A heavier approach could have included facilitating AIG’s orderly dissolution.
For a free market to work, companies must be free to fall, or at least to stumble. The decisive action taken by the Fed and Treasury department might have avoided one depression, but those same actions make the next one seem unavoidable.