Casey Mulligan argues that bank recapitalization under TARP was a failure because it did not lead to increased bank lending. He argues that this was a necessary outcome, because (a) public purchases of bank capital crowd out private purchases of bank capital, and (b) new capital does not necessarily flow into lending, and concludes: “This episode is an expensive example of public policy promises that were doomed to failure because they were known at the outset to defy economic theory.”
I have often argued that there were many things wrong with TARP. But this is not one of them.
First, public capital may crowd out private capital in some theoretical world between the covers of an economics textbook. But what about a world when no one wants to buy private capital? That is a fair description of the state of the world on October 13 last year, when Henry Paulson convinced his former Wall Street colleagues to accept a gift of cheap capital. Yes, Buffett and Mitsubishi had made investments in Goldman and Morgan Stanley, but everyone’s CDS spreads were still going up. Mulligan says, “The market might well react to Treasury share purchases by reducing private holdings of bank capital,” but I don’t know by what mechanism I could take a share of Citigroup down to Midtown and demand cash for it. (Sure, I could sell it, but that doesn’t change the amount of private capital.)
(b) is correct — more capital does not necessarily increase new lending, especially when banks are fearful for their day-to-day survival. But this is where the straw man comes in. The overriding purpose of bank recapitalization was not to increase lending. It was to prevent major banks from failing. The banks were facing both a liquidity and an insolvency crisis. The promise of virtually unlimited liquidity by the Fed had not so far succeeded in stopping the wholesale (as opposed to retail) run on major banks. They needed capital, and they couldn’t get it from anyplace else, so the government stepped in.
Yes, some politicians said that the purpose of TARP was to increase lending. But that’s what they had to say, especially after the House Republicans succeeded in killing the first version of TARP. The main purpose was to prevent a collapse of the financial system, and it succeeded there. Besides, you could argue that TARP did increase lending, because there will be more lending in a world with Citigroup and Bank of America than in a world without them, at least in the medium term. (Yes, the textbook says that supply will meet demand somehow, but the real world doesn’t reach equilibrium instantaneously.)
Now, I could go criticizing TARP for the rest of the day. In short, I would say it succeeded in its most essential mission, but it did so via excessive subsidies to the banking industry, and it left us with a stabilized but sick financial system (remember those toxic assets?) instead of a healthy one. I think the finding that TARP did not increase lending is actually an important one, because it highlights one of the flaws of the government’s response — a more aggressive response could have resulted in a healthier system. But using it as an example of the superiority of Chicago-school economic theory over public policy is a bit much.
By James Kwak