This morning, starting at 9:30am, the Congressional Oversight Panel holds a hearing to assess the performance of the Troubled Asset Relief Program (TARP). The hearing will be streamed live and also archived, featuring testimony from: Dean Baker (Center for Economic and Policy Research), Charles Calomiris (Columbia University), Alex Pollock (American Enterprise Institute), Mark Zandi (Moody’s Economy.com), and me.
In late September 2008, Secretary of the Treasury Henry S. Paulson asked Congress for $700 billion to buy toxic assets from banks, as well as unconditional authority and freedom from judicial review. Many economists and commentators suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands – indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that approach was shelved.
In any case, after the TARP was passed on October 3, 2008, it was quickly overtaken by events. First the UK announced a bank recapitalization program; then, on October 13, it was joined by every major European country, most of which also announced loan guarantees for their banks. On October 14, the US followed suit by using TARP to fund injections of capital into banks, as well as unlimited deposit insurance (for non-interest-bearing accounts), and guarantees of new senior debt.
The overall US policy response to the crisis did well in terms of preventing spending from collapsing. Monetary policy responded quickly and appropriately. After some initial and unfortunate hesitation on the fiscal front, the stimulus of 2009 helped to keep total domestic spending relatively buoyant, despite the contraction in credit and large increase in unemployment. This was in the face of a massive global financial shock – arguably the largest the world has ever seen – and the consequences, in terms of persistently high unemployment, remain severe. But it could have been much worse.
There is no question that passing the TARP was an essential element in restoring confidence. In some countries, the government has the authority to provide fiscal resources directly to the banking system on a huge scale, but in the United States this requires congressional approval. In other countries, foreign loans can be used to bridge any shortfall in domestic financing for the banking system, but the U.S. is too large to ever contemplate borrowing from the IMF or anyone else.
But if any country provides unlimited government support for its financial system, while not implementing orderly bankruptcy-type procedures for insolvent large institutions, and refusing to take on serious governance reform and downsizing for major troubled banks, it would be castigated by the United States and come under pressure from the IMF.
At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand. Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout. That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term. Serious countries do not do this.
Seen in this context, TARP has been badly mismanaged. In its initial implementation, the signals were mixed – particularly as the Bush administration sought to provide support to essentially insolvent banks without taking them over. Standard FDIC-type procedures for failed institutions, which are best practice internationally, were applied to small- and medium-banks, but studiously avoided for large banks. As a result, there was a great deal of confusion in financial markets about what exactly was the Bush/Paulson policy that lay behind various ad hoc deals.
The Obama administration, after some initial hesitation, used “stress tests” to signal unconditional support for the largest financial institutions. By determining officially that these firms did not lack capital – on a forward looking basis – the administration effectively communicated that it was pursuing a strategy of “regulatory forbearance” (much as the US did after the Latin American debt crisis of 1982). The existence of TARP, in that context, made the approach credible – but the availability of unconditional loans from the Federal Reserve remains the bedrock of the strategy.
The downside scenario in the stress tests was overly optimistic, with regard to credit losses in real estate (residential and commercial), credit cards, auto loans, and in terms of the assumed time path for unemployment. As a result, our largest banks remain undercapitalized, given the likely trajectory of the US and global economy. This is a serious impediment to a sustained rebound in the real economy – already reflected in continued tight credit for small- and medium-sized business.
Even more problematic is the underlying incentive to take excessive risk in the financial sector. With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”
The implementation of TARP exacerbated the perception (and the reality) that some financial institutions are “Too Big to Fail.” This lowers their funding costs, enabling them to borrow more and to take more risk. The consequences appear in your tax bill and your job prospects.
By Simon Johnson
An edited version of this post previously appeared on the NYT.com’s Economix blog and is used here with permission. If you would like to reproduce the entire post, please ask the New York Times.