What would be actual consequences if banks (or other large companies) weren’t bailed out by the government. Would financial crashes be worse?
In: Economics
>Would financial crashes be worse?
In most cases, yes. Bailouts in the past have been done to restore or maintain confidence on the financial markets. Smaller investment oriented banks have been allowed to crash (e.g. Lehman Brothers) as the fallout has limited impact – people and organisations who have interests in investments are well aware that there are risks involved.
But larger banks, and especially those who deal in retail banking and business loans, can have a significant cascading effect if they are allowed to fail. If word gets out that those banks are likely to fail, then a run on the bank starts (people withdrawing and transferring all liquidity out of their accounts) which reduces liquidity and makes the fall inevitable. In the case of business loans, people stop borrowing money, which then cripples the flow of money from the other direction.
Basically, the whole global financial system is dependant on flow of money. Once that gets squeezed, it collapses.
Edit: that may all be a bit too oversimplified: there are leveraging effects to take into account, which mean that even some small changes can have an outsized impact, as well as concerns for the different types of money supply (M1, M2, M3 etc))
They would be forced to foreclose on any non-liquid funds to pay off their debts.
Mortgages. Even people that are following their payment plan to the letter.
So in a way, banks use the blackmail of innocent people to take extremely risky large scale investments.
Context? Banks and businesses generally aren’t bailed out, and when they are there’s a specific reason for it (not all the same).
For something like the financial crisis banks were mostly given bridge financing they had to pay back with interest. Letting them all die would have caused more harm for sure, and not had a lot of immediate benefits. Post bailouts maybe a different story, as TBTF banks arguably had lower financing costs than smaller rivals. Though, not a lot of benefits from having stronger small banks.
In the broadest scenario, yes it would be worse. The worst case if the financial system starts to collapse the commercial sector. No company can operate without banking in any developed country. Banks process payments from customers, payments to suppliers, provide credit for companies, provide loans for investments etc etc. Not to mention, it has to handle things like salary payments, transferring payments to pension funds, social security. So in a broad based collapse of banks, the entire economy would probably go into deep crisis.
It would be worse in the short run but probably better in the long run? One thing about financial markets is that they’re not like regular markets, and perception matters more. If people think banks will fail, they will run to get their money out, causing their banks to fail. That doesn’t happen with other businesses. Regulating financial markets is tough because there are so many complicated transactions (many designed to evade regulation), so sometimes the government just has to accept a failure, spend taxpayer money to keep the failure from spreading, and move on.
That said, if they had never bailed out banks, then banks wouldn’t be engaging in behavior that makes crises more likely. If banks were allowed to fail, and even if the contagion spread, the government just said “we’ll reimburse the customers to an extent but F you, banks and bank shareholders” then banks would be a lot more careful about what they do. (The FDIC does this, protecting customers; many economists say that’s where the protection should stop.)
If the banks were not bailed out than vastly more people would have been laid off and lost their homes/futures. People, especially on the left, like to look at those bailouts as helping the wealthy. This is something the left uses as a hammer. The fact is though the bailouts were done to prevent the middle class from collapsing due to government rate hikes, which slows the economy and raises ARM mortgage rates.
Banks hold a bunch of people’s money. If a bank fails and especially if a bunch of banks fail, there is a risk that people lose trust in banks to hold their money and run to their bank to take out all their money. That can cause a really big collapse, since banks don’t actually keep people’s money sitting there (they lend it out). If banks don’t have money they can lend out, a lot of industries will struggle, since buying homes, building commercial buildings, and a lot of other major industries rely on bank loans.
Rich people would lose money….you know we cant have that. Privatize the profits and socialize the losses.
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