The Troubled Asset Relief Program, or TARP, is over – more specifically, its legal authority expires on Sunday, so it cannot be used for new “bailout” activities (although legacy programs, with money already disbursed, could last 5 to 10 years.)
The first draft of its history, looking back over the past two years, may be this: TARP was an essential piece of a necessary evil – that is, it saved the American financial system from collapse — but it was implemented in a way that was excessively favorable to the very bankers who had presided over the collapse. And this sets up exactly the wrong incentives as we head into the next credit cycle.
People who are opposed to bailouts of any kind like to argue that TARP was not really necessary. Banks could have been allowed to fail and the economic fallout around the world would not have been so dramatic.
This was, of course, the view taken by policymakers in 1929-31, after the Great Crash. Top people at the Federal Reserve and Treasury argued that the United States had experienced a financial mania (true), that a fall in asset prices was long overdue (quite likely, at least for stocks), and that the right approach was to stand back and – in the unforgettable words of Treasury Secretary Andrew Mellon — let the private sector “liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” (The exact wording of Mellon’s quote is according to President Hoover’s account, but this was Mellon’s general view; see p.445 of Mellon: An American Life, by David Cannadine).
The result was the Great Depression. No responsible policymaker would want to run that risk again.
Supporting banks by injecting capital is best practice for preventing financial and economic collapse around the world. It was, by the way, not the idea of then-Treasury Secretary Henry Paulson – he wanted to have the government buy up “toxic assets,” an idea that never really got off the ground (too complex, too easy to abuse and inherently nontransparent in deeply scary ways).
It was Representative Barney Frank, the Massachusetts Democrat, who insisted that the Treasury receive the power to provide capital. Within a week of the legislation’s approval, this was the main option on the table and has remained front and center of what the government did in fall 2008 and January 2009, and what it could promise (or threaten, depending on your perspective) to do after the stress tests of spring 2009.
But three serious mistakes were made in the implementation of TARP.
First, there was no need to be so excessively generous to the financial executives (and their boards) at the institutions that had to be saved. In part this generosity was due to insufficient safeguards in the legislation (a point Ken Feinberg makes persuasively with regard to compensation), but mostly this was a choice insisted upon by key people in President Obama’s economic team.
The bankers were not even embarrassed by what happened – this was extraordinary, probably unprecedented and completely at odds with what the very same administration officials had advocated when their advice (and money from the United States and the International Monetary Fund) was needed by other countries (we cover this in detail in Chapter 2 of 13 Bankers). The historical record on this point is not in question.)
Second and closely related, the Obama administration missed the opportunity to change the structure and the incentives of Wall Street when it had the chance, at the very beginning of 2009. The Treasury line, then and now, was that the “essential functions” of the financial system had to be preserved, and this meant no one could be “punished.”
This is again a complete divergence from best practice, for example as recommended by the I.M.F. (with United States backing) in many situations over the last 50 years. The issue is not punishment or retribution; it is responsibility – and it provides incentives to be careful in the future. (Again, for more technical details, see 13 Bankers.)
Failing to seize an opportunity for reform is not sophisticated or the work of adults (as some members of the Obama administration self-servingly assert); it was simply a political mistake – and terrible economics. The idea that some banks were too big to fail arguably played a role in the run up to 2007-8; we can have that debate. But the notion that our biggest six banks are untouchable today is uncontroversial.
Their creditors know this, so these banks can borrow more cheaply than their smaller competitors, they can become larger relative to the economy, and if you doubt the risks that this poses, just look at the situation today in Ireland.
Third, by the time the administration put forward its financial reform ideas, the big banks were back on their feet – and ready to throw huge numbers of lobbyists and unlimited cash into the fight to preserve their right to take inordinate risk and to mismanage their way into disaster.
The administration’s proposals were weak to start with and were diluted by the House of Representatives (with a very few holding actions, most notably by Representative Paul Kanjorski). Surprisingly, and against great odds, the legislation was not gutted in the Senate – due primarily to the efforts of Paul Volcker (from the outside) and Senators Kaufman, Levin, Brown, and Merkley, the reforms became a little bit stronger. But the Dodd-Frank Act, while including some sensible consumer-protection measures, essentially does very little to reduce system risk as we move into a new credit cycle. In particular, there is nothing that ensures our biggest banks will be safe enough or small enough or simple enough so that in the future they cannot demand bailouts – the bailout potential exists as long as the government reasonably fears global financial panic if such banks are allowed to default on their debts
Where do we stand today, with the Financial Stability Oversight Council meeting for the first time tomorrow? In a devastating speech last week, Mr. Volcker hit all the nails on the head – our financial system is badly broken. This will lead another runaway mania and another awful collapse.
Read the farewell speech this weekfrom Senator Ted Kaufman of Delaware to the Senate. Drawing the right lessons from the crisis and looking forward, with particular concern for the way “high-frequency trading” adds an extra level of opaqueness and risk to the system, he makes an impassioned plea for what is, in effect, a more pro-business approach (indeed, it’s in the interest of almost everyone engaged in the financial system).
“We cannot afford regulatory capture, nor can we afford consensus regulation, not in any government agency,” he said, especially the Securities and Exchange Commission, “which oversees such a systemic, and fundamental, aspect of our entire economy.”
“[I]f we fail, if we do not act boldly, if the status quo prevails, I genuinely fear we will be passing on to my grandchildren a substantially diminished America – one where saving and investing for retirement is no longer widely practiced by a generation of Americans and where companies no longer spring forth from the well of capital flows that our markets used to provide.”
TARP is gone, but we must not forget its lessons.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire post, please contact the New York Times.