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									What Would Happen If We Hadn’t Bailed Out
the Banks and others?
In America today – and in the rest of the world – economic-policy centrists are being
squeezed. The Economic Policy Institute reports a poll showing that Americans
overwhelmingly believe that the economic policies of the past year have greatly enriched
the big bankers at the expense of the public good.

Today in America, the Republican congressional caucus is just saying no: no to short-
term deficit spending (that Democrats claim will put people to work), no to supporting
the banking system (that world renowned economists of Harvard, Yale, Stanford, the
conservative Kato Institute and Nobel laureates all claim are necessary to keep America
financially and socially stable), and no to increased government oversight or ownership
of financial entities. And the banks themselves are back to business-as-usual: anxious to
block any financial-sector reform and trusting congressmen eager for campaign
contributions to delay and disrupt the legislative process.

Nevertheless, policy over the past two and a half years has been good. A fundamental
shock bigger than the one in 1929-1930 hit a financial system that was much more
vulnerable to shocks than was the case back then. Despite this, unemployment will peak
at around 10%, rather than at 24%, as it did in the US during the Great Depression, while
nonfarm unemployment will peak at 10.5%, rather than at 30%. Nor will we have a lost
decade to economic stagnation, as Japan did in the 1990’s. Admittedly, the bar is low
when making this comparison. But our policymakers did clear it.

It is worth stepping back and asking: What would the world economy look like today if
policymakers had acceded to the populist demand of no support to the bankers? What
would the world economy look like today if Congressional Republican opposition to the
Troubled Asset Relief Program (TARP) program and additional deficit spending to
stimulate recovery had won the day?

TARP: Bailing out the Banks

As investment banks, lending banks, and main street banks were facing collapse, and
ATM machines around the U.S. were about to be switched off, Congress and our exiting
President Bush--and then our the new President Obama--created a $700 Billion bank
rescue fund known as TARP: Troubled Asset Relief Program. This was massive fund
was designed to give the Federal Reserve all possible room to maneuver many fixes to
our failing economic systems.

Though many argue that not all banks would have ''collapsed,” no economist with a
college degree was willing to say we were not about to enter a “depression.” None. Only
politicians and talk show pundits railed that bank collapses would lead to a stronger
America over time. Economists of the left and the right began to voice strong concern as
banks began to halt issuing credit as they were suddenly faced with a far more ''real''
approximation of how much money they had in their possession that they could give out.
All saw that mortgage payments began to spiral while companies cut back or went bust as
they could not take loans to cover their current normal schemes of operating costs. In the
long term we were faced with massively lower spending by companies and consumers,
causing further economic contraction leading to a depression lasting years, similar to that
of 1929. Then, in the event of a depression, there would have been a world-wide “run” on
the dollar, which all economists admitted was something that did look like it could
wander into the “collapse scenarios.”

The only natural historical analogy is the Great Depression itself. That is the only time
when (a) a financial crisis caused a widespread, lengthy, and prolonged chain of bank
failures, and (b) the government neither intervened nor passed the baton to a
consortium of private banks to support the system as a whole.

Two years ago, Lehman Brothers (an investment bank) collapsed. It consequently
defaulted on its short-term debt that large, generally very safe companies issue to fund
their operating expenses (primarily raw materials and wages). This lead a its holdings
falling to $1/share, so investors had lost money. Since this was a very rare event and
investing in investment banks like Lehman Brothers, Goldman Sachs, Chase, and others
had always been considered extremely safe, a huge panic ensued, causing a run at selling
stocks and bonds in these large investment banks. The market for stock in these
investment banks consequently dried up and there was almost no lending going on. Even
banks (of all kinds and sizes) were having a hard time getting more than overnight loans
(to keep them liquid for the next day’s business).

Without overnight loans, enterprises of all sorts (both financial and nonfinancial) would
have likely defaulted even though they were mostly solvent. This is because even though
their assets are generally greater than their liabilities, they would not have been able to
come up with the cash necessary to settle the immediate claims on them (like payroll or
credit for goods in retail channels, or both). So they would have been forced into default.
This would have scared investors of Investment Banks even more (and again, this is
generally considered a very safe market), amplifying the problems in all Investment
Banks and regular banks, and so on. When the financial system is functioning smoothly,
the collapse of one large bank might be manageable. But in the fall of 2008 the system
was in chaos. The potential for widespread damage was heightened by the collapse of
Lehman Bros., the investment-banking firm that was denied a government lifeline. The
unexpected reverberations from the demise of that single, medium-sized Wall Street
institution forced government officials to rethink their tough stance.

It is now 19 months after investment bank Bear Stearns failed (an investment bank that
had been in operation for 132 years) and was taken over by JP MorganChase--with the
assistance of up to $30 billion of Federal Reserve money on March 16, 2008, and
America’s industrial production stands 14% below its peak in 2007. By contrast, 19
months after the famed private bank, “Bank of the United States,” failed on December
11, 1930, with 450,000 depositors, industrial production, according to the Federal
Reserve index, was 54% below its 1929 peak.

With a complete collapse of these Investment Banks, which make money through (among
other things) short-term lending to regular main street banks, all industry would have
halted very quickly. Then, only a “trading shutdown” would have stopped the Dow from
shedding half its value. Most of the U.S. banking system would be insolvent.
Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an
independent central bank and setting the money supply would be a crapshoot. The rate
of unemployment would climb into double digits and stay there. Many Americans
would not have access to their savings. The future supply of foreign investment would
be noticeably lower. The Federal government would lose its AAA rating and we would
pay much more in borrowing costs. The deficit would skyrocket.
This would have very quickly lead to an overall economic situation probably far worse
than anything seen in the Great Depression. "It was clear that when Lehman Bros. went
down, we were within hours of no ATM machines working any more," said GOP
strategist Rich Galen. The bailout "was unfortunately necessary."

Opponents of recent economic policy rebel against the hypothesis that an absence of
government intervention and support could produce an economic decline of that
magnitude today. After all, modern economies are stable and stubborn things. Market
systems are resilient webs that offer the best possible incentives to people to make deals
and use resources productively. A 54% fall in industrial production between its 2007
peak and today is inconceivable – isn’t it?

If The Fed had let more large Investment Banks like Citibank or Wamu collapse next, it
would only be a matter of time (probably not even very much time) before there would
have been a run on all banks. I highly doubt even one major US bank would have

So in that specific sense, I think the government interventions with investment banks
(like Chase), lending banks (like Fannie Mae), and main street banks have been very
successful. The whole credit system would have collapsed months ago if they had just let
everything go.

Bailouts Beyond the Banks

The list of bailout recipients doesn't stop with the Banks. Some $50 billion went to try to
save the auto industry through partial government takeovers of General Motors and
Chrysler. In theory at least some of that money will come back to the Treasury as the
companies are overhauled and continue restructuring. This money to the auto industry is
really a loan, with the U.S. government holding all of these companies’ stock. GM is
expected to eventually sell stock to the public again, but that could be years away.

Another $75 billion was supposed to help stop the home foreclosures that are deflating
the value of mortgage-backed bonds, and deflating the value of homes. Many
homeowners were walking away from their mortgages, inviting the foreclosure process,
as many went unemployed and others were disgusted with the low value their homes now
held with the collapse of the market (in that they were now in debt for far more than their
house might ever be worth again). The money was to be used to help home-owners
refinance their homes for a cheaper interest rate and longer terms. Yet, that part of the
plan has done little so far to stem the tide.

As of last month, two years after the government began trying to help homeowners, some
31,000 loans had been permanently modified. There were roughly 4 million foreclosures
this year alone. Another 3.5 million homeowners are seriously in default. Without real
relief, another 3 million are expected to default over the next two years. Until the lending
industry gets serious about its foreclosure problem, it faces continued losses for years.

As the authorization to use the TARP fund comes to an end this month, Congress is
already talking about using some of the money to extend unemployment benefits. The
banking industry still faces the prospect of defaults on a huge pile of commercial real
estate debt that needs to be refinanced in the next few years. Federal mortgage providers
Fannie Mae and Freddie Mac are still essentially broke.

Despite the political venom, the program has turned out to be far less expensive than the
original $700 billion price tag.

As of Sept. 30, the government had spent $388 billion of the $700 billion TARP, and
$204 billion of that has been repaid, the Treasury Department said Tuesday in a "Two-
Year Retrospective" of the program. Furthermore, the government has received about
$30 billion in interest, dividends and stock sales. Thus, taxpayers right now are on the
hook for about $154 billion. But that doesn't include future income and gains from stocks
and other assets still held by the government from aid recipients.

With these figures in mind, the White House projects that the once-awesome $700 billion
program will end up costing about $50 billion, possibly less. That's down from the $66
billion the nonpartisan Congressional Budget Office estimated in August. Some
administration officials suggest that in the long run, after interest payments and stock
sell-offs, all the bailouts and TARP actions could even wind up earning taxpayers a small

Treasury Secretary Timothy Geithner, in a cover letter to Tuesday's report, reminded
Congress that the legislation had strong bipartisan support when passed. President Bush,
with the support of Republicans and Democrats in Congress, started the bailout funding.
President Obama took office and continued with the bailout plans. Since then, he said,
"many have lost sight of the pressing need" for the program and have criticized it —
wrongly, he suggested.

There are those that say that things would not have been so bad if the government had
refused to implement an expansionary fiscal policy, recapitalize banks, nationalize
troubled institutions, and buy financial assets in non-standard ways. The problem,
though, is that all the reasons to think that depressions as deep as the Great Depression
simply do not happen to market economies apply just as well to the 1930’s as they do to

All these collapses did indeed happen in 1930. And they could have happened again.

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