Should the government bail out big banks that may otherwise go bankrupt? Or should it let them go under, as it did with Lehman Brothers in 2008? Economist Nicole Gelinas, a fellow at the Manhattan Institute, has the answer, and it will have big implications for policymakers when they grapple with the next economic crisis.

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Script:

In 2008, America experienced the biggest meltdown of its financial sector since the Great Depression. The conventional wisdom is that this failure and subsequent government rescue, commonly known as “the bailout” was brought about by three decades of bank de-regulation. There were a lot of causes for the meltdown, but deregulation wasn’t one of them. Ironically, it wasn’t because the banks had become unmoored from government control that led them into the financial storm, it was because they had become too closely tied to government. For three decades Uncle Sam, like an enabling parent, had always “been there” when the big banks got into trouble. The shock in 2008 was that for one brief moment, Uncle Sam wasn’t there.

In the wee hours of September 15, 2008, Lehman Brothers filed for bankruptcy. The financial industry waited for the Feds to step in and save Lehman bondholders like it saved those of Bear Stearns some months earlier. That didn’t happen. Global financial markets seized up. As the Dow Jones Industrial average fell 498 points, or nearly 4.4 percent, financial institutions effectively went on strike. Banks wouldn’t lend money to other banks and thus, indirectly, to the public because they had no idea which financial institution might go belly up next. The economy can withstand a stock-market crash, but a credit-market freeze — essentially a cash freeze — can cause a Depression, as credit underpins almost all business and personal activities. Indeed, some large companies, including General Electric, were so dependent on these short-term credit markets that they were in danger of not being able to pay their workers.

The financial industry pleaded with the government to act. Later in the same day, September 15, it did. The Feds wouldn’t save Lehman’s but it would save AIG, the primary insurer of mortgage loans. A month later, the Troubled Asset Relief Program (TARP), a $700 billion plan to pump taxpayer cash into America’s banks and financial institutions was approved by Congress.

Public officials generally agreed that the free market had failed. In November 2008, President George W. Bush came to New York to explain why he, a Republican president, had signed TARP into law. “I’m a market-oriented guy, but not when I’m faced with the prospect of a global meltdown,” he said.

But free-market capitalism had not melted down. Again, the problem was not that banks had been too free, but that they had grown too dependent on government over the last few decades. Here’s a brief history.

America’s first post-Depression bailout of a big bank came in 1984 when the Republican administration of Ronald Reagan, with help from the Federal Reserve bailed out Continental Illinois, the eighth largest commercial bank in the nation. The bailout introduced the phrase “too big to fail” to the financial media’s vocabulary.

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Should Government Bail Out Big Banks?

The financial crisis of 2008 raised questions about the role of government in rescuing big banks during times of economic turmoil. When faced with the collapse of major financial institutions, governments around the world grappled with the decision of whether to provide a bailout or allow these banks to fail. This dilemma has ignited heated debates regarding the appropriate role of government intervention in the economy. While opinions on this matter may vary, there are several arguments for and against government bailouts of big banks.

Proponents argue that governments should bail out big banks due to their significant impact on the overall economy. Big banks are often deeply interconnected, with their failures potentially triggering a domino effect throughout the financial system. If one major bank were to fail, it could lead to a crisis of confidence, causing depositors to panic and withdraw their funds from other banks, instigating a wider collapse of the entire financial system. The economic consequences would be severe, potentially leading to widespread unemployment, a decrease in lending, and a substantial decrease in economic growth. By providing a bailout, governments can prevent a full-scale financial collapse and thus mitigate the negative impact on the economy.

Furthermore, proponents argue that the failure of big banks could have severe social consequences. When banks collapse, individuals and businesses who rely on their services can suffer greatly. For example, businesses may struggle to secure loans, leading to layoffs and economic setbacks. Individuals can also face challenges accessing their funds, making it difficult to pay bills or meet other essential expenses. By bailing out big banks, governments can prevent such turmoil, stabilizing the financial sector and safeguarding the well-being of individuals and businesses alike.

However, critics of government bailouts argue that such interventions perpetuate moral hazard. When banks know that they will be bailed out by the government in times of crisis, they are more likely to take excessive risks, knowing that they will not bear the full consequences of their actions. This moral hazard incentivizes reckless behavior and undermines the financial industry’s ability to self-regulate. Moreover, critics argue that bailouts create an unfair advantage for big banks, as they are essentially shielded from the normal market consequences of their risky decisions, while smaller banks and businesses face the full brunt of market forces.

Critics also claim that government bailouts seem to prioritize the interests of big banks over those of ordinary taxpayers. Using taxpayer money to rescue failing banks can be seen as protecting the interests of the wealthy elite at the expense of ordinary citizens who bear the burden of a struggling economy. Critics argue that governments should focus their resources on creating an environment in which banks and businesses operate responsibly and are held accountable for their actions, rather than providing blanket bailouts.

In conclusion, the question of whether governments should bail out big banks remains complex and highly debated. Proponents emphasize the potential systemic risks and social consequences that could arise from their failure, while critics argue that bailouts breed moral hazard and prioritize the interests of the financial elite over the average citizen. Striking a balance between protecting the economy and ensuring accountability within the banking sector poses a formidable challenge for policymakers. Ultimately, the decision to provide government bailouts to big banks should be carefully considered, taking into account the specific circumstances, potential alternatives, and long-term consequences.