citigroup building new york cityWe’re coming up on the wooden anniversary of the bailouts this year. Apparently to celebrate five years you give wood. Back in 2008 our government bailout out a financial system that had suddenly locked up. No bank would lend to another, and they all had toxic assets on their balance sheets. Some banks died, most were saved. Shareholders suffered, bondholders did not. Now with the benefit of hindsight we can look back on whether it should have been done in the first place.

Zocolo Public Square asked some economists and financial observers what they thought. In general, most believe that we did need to bailout the banks but not enough has been done to keep us from having to do it again.

For the most part I agree with this. Dating back to the 1980s, our government established the precedent that in the event of financial catastrophe, they would provide stabilization. Such stabilization is often of the benefit to those that lend to the failed institutions. This implicit moral hazard made it easy for people to lend to banks and similar institutions. There isn’t much risk if the government will bail you out, so the thought went.

Through the 90s and 2000s this trend continued. Failures were often rare and isolated, but regularly the creditors were saved to keep the peace. The bailouts were a reluctant acceptance of the realities at the time. Yes there is plenty of blame to go around. Banks were greedy, mortgage brokers were willingly ignorant, and the government fostered the environment that allowed it all to happen.

No one wanted to bailout the banks. But because of the crisis at hand, it was probably the right decision. The damage that a locked up lending market could do to our economy is immeasurable. If there was ever an event that could send us back to the days of bartering, it would be a credit crisis that is allowed to unfold. By bailing out the banks, the government likely kept a recession from becoming a depression.

None of that means anything today though. What we should be concerned about now is if we will allow this to happen again. Five years ago we were in the trauma unit, suffering from 3rd degree burns, internal bleeding, and organ failure. Now we’re in rehab. How do we make sure we don’t end up here again?

Unfortunately, perhaps not enough has been done in that department. While the government has established better mechanisms to isolate a crisis (like cutting off a foot before infection spreads), we don’t really know how effective it will be. New regulations such as Basel III and the stress tests help to make a crisis less likely. However, we still have very large banks that are systematically important to the economy. Many believe the banks should be broken up.

Such a case is arguable. There is however no guarantee that such an action would actually prevent a crisis. The whole system can still become interconnected no matter the size of an institution. Through contracting and lending activities, a network of small banks is no different than a web of large ones. Without a return to an extremely regulated environment, we can’t remove all the risk. Such a regulated environment would open the doors for new risks as well.

I’m not standing on stable ground with how I feel. We can’t really say we’re better off thanks the bailouts. The pain we avoided with them today may be offset down the road by an even worse situation. But fear, and even hindsight, shouldn’t keep us from pushing forward.

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categories: banking, government