Money to Burn: Was the Bank Bailout Really Necessary?

US Treasury secretary Timothy Geithner says that we don't need to bail out the banks anymore based on the results of his stress tests. We should follow up quickly on his assessment and start shutting the special Fed lending facilities enjoyed by the banks, the FDIC loan guarantee programme and the AIG slush fund.

However,
given the hundreds of billions that have already gone out the door, it
is still worth asking whether this bailout was necessary. The argument
made by many economists was that it would cost taxpayers more money to
do an FDIC-type takeover
of banking behemoths like Citigroup and Bank of America than the tens
of billions handed over to keep them afloat. In their story, the
taxpayer bailout of bank stockholders, bondholders and top management
was an unfortunate side effect.

While the next step in this
argument is a calculation of the cost of a bite-the-bullet now approach
versus a handout-and-wait strategy. With the right assumptions, the
handout-and-wait strategy can be shown to come out on top, so we really
were just helping ourselves when we gave hundreds of billions of
dollars to the bankers that wrecked the economy.

But this
calculation not only requires a very specific set of assumptions, it
also requires some really bad logic, a commodity supplied in abundance
by nation's top economists. The economists claimed that killing the zombie banks would cost more money because it would effectively set in motion a bank run.

The
argument goes that people would withdraw money even from insured
deposits. The result would be that the government would suddenly be
liable to make good on all the banks' deposits, which could easily
exceed the value of their assets by more than $1tn. The economists
argued that it was better to have costly bailouts than to deal with a
massive collapse.

To see the fallacy in the economists' logic,
suppose that the banks' depositors gathered together $1tn in cash.
Suppose they accidentally set the cash on fire and burnt it up so that
$1tn in cash no longer existed.

What if the government then
stepped in and replaced the lost money. However, instead of borrowing
money in the bond market, it simply printed up another $1tn in cash. In
this case, there is no greater debt burden on the government in the
future, since the $1tn has no interest costs.

Nor is there any
threat of inflation as a result of the printing up an additional $1tn.
The newly minted $1tn simply replaced $1tn that was destroyed. There is
no more money in circulation as a result of this printing than there
had been before the big fire.

In short, replacing the $1tn
destroyed by the fire imposes no real cost on the government at all.
(If this all sounds a little too fast and loose, it is. If we let the
depositors suffer their $1tn loss, then the rest of us would be richer
as a result. The depositors would have less claim on the economy's
output, leaving more for the rest of us.)

How does this relate
to the great bank heist of 2008-2009? It's very simple. If we actually
got the scary bank runs described by the leading economists, then the
Fed could just print the money needed to make the depositors whole.
This additional money would not add in any real sense to the
government's debt burden. We would just be replacing money that had
effectively disappeared with new money. This would impose no additional
interest costs, nor would it increase the threat of inflation.

The
great benefit of going this route is that it would not use taxpayer
dollars to reward the bankers executives who got us into this mess, and
the bondholders and stockholders who were foolish enough to trust them
with their money. We could honour all guaranteed deposits while
allowing the bondholders and stockholders to enjoy the full fruit of
their risk-taking. In other words, they would get wiped out, which is
what is supposed to happen in a capitalist economy.

We would also
replace the bank executives with more competent people, who presumably
would work for much lower pay. As quickly as possible the banks would
be restructured and then sold back to the private sector. That is the
way things are supposed to work in a market economy.

In short,
there were really no legitimate horror stories, at least from the
taxpayers' side. The horror stories were only horror stories for the
bank executives and their bondholders and shareholders. The economists
who missed the housing bubble helped to deceive the public yet again
and steer more taxpayer dollars in the pockets of this wealthy clique.