Thursday, September 30, 2010

The Legacy of TARP

Today, Simon Johnson considers the long-term implications of TARP:
TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse, but it was put in place in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.
A couple of weeks Ryan Avent reached the same conclusion:
[G]overnment interventions, of which the TARP was a key part, prevented what leaders in the early 1930s did not—a cascade of wealth-destroying, money-supply shrinking bank failures. And because the interventions successfully halted the cycle of fear in financial markets, the programme ended up costing practically nothing... The truth is that the TARP, despite the profit, has come with significant negative costs. It has preserved the structure of the banking system in its current, over-concentrated, too-big-to-fail form. And it has created an absolutely massive moral hazard problem. And so in a way, we're all still paying the cost of TARP, because the legacy of that intervention continues act as a de facto subsidy to size and risk. And one day that bill may come due, in the form of another costly crisis.
 There are other observers, on the other hand, who sing nothing but praise for TARP. If it were possible, it would be useful to look at the difference between (1) the net present value of  future costs created by TARP and (2) the costs that would have been incurred in 2008 and 2009 had there been no TARP.  Of course, such a calculation is not possible because (1) requires knowledge of the future and (2) requires knowledge of a counterfactual.  One thing, though, does seems sure to me: the moral hazard problem is now bigger than ever. 


  1. Hmmm.... Reading Johnson's post, I think the comparison that he would want would be the present value of costs created by TARP versus a counterfactual with some idealized version that dealt better with incentives/"Too Big To Fail." I don't think he's saying that we would have been better off doing nothing (though that's an interesting question too).

  2. And of course TARP represents only a portion of the support given to the financial system. It does not include the extraordinary actions taken by the Federal Reserve to shore it up, and which are still ongoing in the form of damagingly low interest rates.

    Simon Johnson has been convincing in his portrayal of the crisis being as much political as economic. The power of the vested financial interests explains not only financial instability but also why America's long-run growth trend is deteriorating.

  3. "One thing, though, does seem sure to me: the moral hazard problem is now bigger than ever."

    How can you be so certain that changes in Basel capital requirements, etc. and other regulatory changes (e.g. resolution authority) will not have the effect of net reducing moral hazard? How do you measure that?

    I wouldn’t be so sure, myself. Moral hazard is roughly the tail risk beyond the ability of equity capital or debt resolution to absorb losses smoothly, and this type of overall capital structure standard is set to evolve into something more resistant than before. Will it be sufficient? Hard to say right now.

  4. Bill C: Yes, that was my comparison not Johnson's. However, the TBTF issue never got addressed with TARP. The one sure way to have addressed it would have been to let the banks fail. That was the motivation for the comparison.

    JKH:Okay, maybe so but the abscence of pushback from the banks (at least what I can see) on the new Basel requirements sure seems suspicious. Any thoughts?

  5. JKH says: "Will it (Basel III) be sufficient? Hard to say right now."

    Which of course is exactly why some of the more perceptive Fed people (such as Gary Stern or Richard Fisher) have argued that the big banks need to be broken up. The history of banking shows that banks are brilliant at beating the regulators. So financial reform requires finding a way to dismantle systemic risk. The regulator shouldn't care if a bank goes under - it's the system they are supposed to protect.

    We learn from the Austrian school to beware of the pretense of knowledge. Basel III would be a great example of pretense. In a world where regulators really don't know what they are doing, the financial system has to be "robustified" so that when a bank fails, it doesn't bring down the whole economy. That surely means breaking up the big banks.

  6. David,

    I have no great insight into whether or not it’s enough, but increasing capital requirements is the key. It's directionally constructive at least.

    I come from a culture in which the banks are not known for deliberately destructive risk taking. Their behaviour even includes a different kind of push back. The Canadian banks got together about a year ago and went to the Canadian version of Fannie (CMHC) to push (successfully) for tighter mortgage underwriting standards for the industry – an example of the exercise of some collective responsibility in order to avoid destructive competitive behaviour (originating mostly from the non bank financial players).

    The Canadian banks are also much larger than the US banks in proportion to the size of the economy - safest system in the world. Size is not the problem per se. Size combined with other problems likely is.

  7. I'm not convinced that moral hazard is a bad thing. In a world where human capital cannot be diversified, there is an underlying incentive to take less than the socially optimal amount of risk. If moral hazard increases risk taking, it may be a second best optimum. Moreover, it is a good thing if people expect bailouts once a financial crisis has begun, because it will prevent the crisis from becoming a disaster. (The recent crisis became a bit of a disaster when these expectations were frustrated in the case of Lehman.)

    In any case, I'm not convinced that TARP has increased moral hazard. It is widely hated by the general public and will be more difficult next time around. If anything, I would say that the damage done by TARP is not that it increased moral hazard but that it reduced it.

  8. Andy Harless makes a good point when he says that the current institutions of American capitalism potentially reduce the "socially optimal" amount of risk-taking.

    American capitalism with its grotesque inequalities of opportunity is a way from optimal compared to some other countries such as maybe Canada and Australia.

    But really....bailing out the banks is the solution ? Come off it ! I don't think the casino risks that Wall St has come to specialize in are the sort of risks you had in mind.

    You want more people to take risks on entrepreneurial activity or education that produces consumer utility not rents for oligarchs.

    In fact, the state-Wall Street nexus is achieving the antithesis of what you want because the flow of rents is pulling talented people into useless activities.

    Let's see if we can find some better institutional reforms to get to where you want to be.

  9. JKH:

    This is off topic, but I have a question you are well suited to answer. Prior to this crisis, it was well documented that the federal funds rate was becoming increasingly predictable. Did this development have any bearing on the elasticity of demand for bank reserves?