Thursday, May 21, 2009

The fraud of the Bank Run Scare

Where the case is made that it would have been better, cheaper, and less inflationary for the government to simply print money to replace the missing funds of failed banks rather than bail them out.

Dean Baker in

Was the bank bailout necessary?

Saving zombie banks supposedly prevented financial collapse. But would letting them fail really have been so bad?

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.

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