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
There’s good responses already but another factor is these big banks are not just US institutions but global banking leaders, letting them fail would have let foreign institutions take that role and keeping the US the leader in financial markets is of strategic interest to the US.
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.
Because a fish only feeds you for a day, a fishing pole will stretch much further.
When banks and insurance companies fall, a lot of employers would go with them and everyone would be unemployed.
Basically, the money you and I have is only good as long as you and I both think it is. Money is in a lot of ways a confidence game. But usually this doesn’t bother us because “the banks” are around as a kind of creaky grown up who’s supervising the rest of us who are kind of just playing store with our money.
What happened in 2008 was that the banks honestly fucked around hard. And when they first started finding out it was really scary because it happened really fast. The first bank that went down I don’t think was actually a bank. But it was called Bear Sterns and went down in like twelve or eighteen hours. Bear Sterns was publicly traded. So a lot of rich people lost money but also a lot of regular people like you and me.
When this happened the government panicked. They made J.p. Morgan buy Bear Sterns so that they could get some of the money back for people. But two things became more apparent when the next financial institution (Lehman Brothers) went down three or four months later.
1 – when banks/financial institutions go down, it’s not just the depositors who lose money. Banking is too connected now. So Lehman Brothers going bankrupt was now affecting a bunch of different people whose money was now locked up because they’d been doing business with Lehman or they had accounts there and they couldn’t get it at a time when they really needed it.
2- when Lehman brothers went down everyone learned the wrong lesson. They didn’t learn “this company fucked around and found out” which was the lesson the government was clearly trying to teach. They learned “Lehman went under and every person who stayed to the end is fucked now”. Which is basically how you get a run on everyone all at once, because now your money isn’t safe anywhere. So banks that were actually fine (they’d lost money but nothing really problematic) started being in danger because they were there and they had peoples money and people were scared to wait too long to get it and then not be able to. Things were getting a bit shaky.
The AIG blew up. AIG was stupid. They didn’t mean to be but they were. They made bad bets and they made a lot of them and they didn’t think this was a problem because they had a lot of assets. Which is totally true. But AIG was cash poor. Insurance is very regulated (likely due to the long tradition of insurers screwing people) so alot of their assets weren’t things they could sell. The bets they made were like a bad insurance policy and all of a sudden everyone was trying to cash in at once. They owed a lot of people a lot of money. And AIG was more connected than a lot of the really big financial institutions. They were in a lot of places and if they suddenly disappeared then everyone was going to get screwed instead of just the people who were unlucky enough to be connected somehow to Lehman Brothers.
What the government (Hank Paulson and Ben Bernanke to be specific) were worried about wasn’t that a few places were going to go out of business. They were worried that money was going to stop working. For everyone. In regular everyday life things. And then people were going to get scared and they were going to get mean. And Paulson and Bernanke thought they could fix it with like an obscene amount of money to AIG so they did. They loaned AIG the money and then they made the banks all take some too so people would see that the banks were ok because the government said so. The government gave them money and the government promised they were ok. They were hoping people would buy that because it’s how we’ve always understood the system to work. And enough of us did. And they did manage to stop the bank run.
Essentially all of the bailout money was paid back to the Federal government, which was then free to spend it on other things. The problem was that banks were *insolvent* in the short term, and unable to perform their usual function (of lending money and hence increasing the practical number of dollars in the world). Bailing the banks out was a moral hazard to be sure, but it also prevented an economic collapse similar to the one that occurred in 1929.
It’s important to remember that government debt is the *basis of our currency*, so the government borrowing money is the main way that we make more currency. Government overspending has the same function for our economy that gold mining once did (in the 19th century). It creates more money, which lubricates literally everything we do that requires buying, selling, or renting stuff.
Money creation (“mining”) is so important that the government can and will, if necessary, borrow money specifically to blow shit up out in the desert (i.e. to waste the money they borrow). That is exactly as productive, from the global perspective, as gold mining was 120 years ago (i.e. not at all, except for creating more money). The government debt is then used by banks to create even more money — which then circulates, allowing people to buy and sell stuff. That process is a little weird for an ELI5, but it works.
The huge benefit of anchoring the dollar to government debt, rather than to precious metal, is that the amount of government debt can be tuned to match the number of dollars in the world to the amount of buying and selling that needs to go on to keep everyone fed.
That is important because large economies work in non-intuitive ways, and keeping enough money moving around is just as important to an economy as keeping enough oil moving around is to an automobile engine (and for similar reasons). If there isn’t enough oil in your car, the engine won’t run long and will seize. The same thing happens to entire economies when there isn’t enough currency to go around.
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