Instead of bailing out the institutions, why didn’t the government just let them fail and give the money directly to the people hurt by the bank’s mismanagement? Why were the banks’ protected? Doesn’t this kind of protection incentivize banks to act recklessly in the future?
In: Economics
The problem, fundamentally, was liquidity.
The banks and lending institutions were panicking because they discovered they were over-leveraged as a result of buying collateralized debt obligations with fantasy land ratings. Because of this, the lenders were refusing to lend and the liquidity markets began to freeze.
The thing is, just about everything relies on short-term loans for day-to-day operations. Everything from businesses to payroll, to credit cards. If they can’t get the loans, then they can’t operate.
This would be made even worse if people also panicked thinking their money wasn’t safe in banks and initiated a national-scale bank run. Since banks run on a fractional reserve system, they only keep so much money on hand. With liquidity frozen, they wouldn’t be able to make up the shortfall. People wouldn’t get their money, and then all hell would break loose.
To prevent that from happening, Uncle Sam stepped in and became the backstop. The lender of last resort. The government bailed out the banks to reassure people that their money is safe, while also unfreezing the liquidity market.
If the government hadn’t bailed out the banks and acted as the backstop, then I very much doubt this country would still exist today. Social order breaks down pretty fast when people don’t get their paychecks, can’t get money out of the bank, and can’t buy food.
It was the lesser of two evils.
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