Casey Mulligan’s Straw Man

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

37 thoughts on “Casey Mulligan’s Straw Man

  1. “Yes, some politicians said that the purpose of TARP was to increase lending.”

    Notably Henry Paulson. Yes. it was a white lie.

    ” 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.”

    What if we had shored up banks smaller than them, so they could buy up the remnants? (I know, that would have been worse for the economy as a whole. Just sayin’! ;))

  2. 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.

    So even if it did succeed in that way (which proposition begs lots of questions and may also be an example of post hoc ergo propter hoc), whether or not it was worth doing at such a cost and leaving such a loathesome aftermath (and which is certainly only setting us up for the next crash) is still a very open question.

  3. Here Here! The total failure of any kind of regulatory package (yet), the continued shrinking of the retail credit market, the excessive compensation to bank managers – all point to an abject failure of TARP, Treasury, and the Fed to actually do anything other then preserve the status quo. That may be what the financail sector paid for with its political campaign contributions, but sooner or later we the People need to demand that we get paid for the risks taken in our names.

  4. The sole purpose of the bailout was to save Goldman Sachs. That was more or less accomplished by the rescue of AIG. The only effect of the bailout has been to return the banks to speculative lending. Please explain why the failure of Goldman, BofA, Citi, a half dozen Swiss, German and British Banks would have created a crisis. You cannot do it. The whole crisis thing is and has been a complete fraud. Suppose all the big banks failed? Failure means nothing more than capital reorganization. New owners replace old owners. Asset values fall. When they fall far enough the real economy picks up. What happens this way? The real economy grinds to a halt, slowly. Lending is diverted to speculation. The government and the Fed have introduced a tidal wave of new money, while the old money never disappeared, it just changed hands. The major banks continue as betting parlors. Discussing the ‘ideas’ of Chicago economists is a complete waste of time and energy.

  5. Casey Mulligan also argues in a recent paper that the great recession was largely caused by increased preferences for leisure caused by disincentives to work, such as mortgage modifications and tax forgiveness plans (, quoted by Willem Buiter i.e. the Great Recession is just a collective vacation. His argument comes replete with modified econ 101 graphs of marginal rates of substitution between leisure and other goods. I don’t know how anyone who’s read the news or watched cable news over the past 18 months could believe this, but there you have it. All those crying homeowners and demoralized unemployed people just weren’t enjoying their vacations.
    Mulligan also argued in an October 2008 op-ed ( that a collapse of the banking sector would be no big deal for the economy: “And if it takes a while for banks and lenders to get up and running again, what’s the big deal? Saving and investment are themselves not essential to the economy in the short term. Businesses could postpone their investments for a few quarters with a fairly small effect on Americans’ living standards. How harmful would it be to wait nine more months for a new car or an addition to your house?” I guess he never heard of commercial paper.
    This all seems to point to the danger of an axiomatic application of economic theory, and to the pitfalls of not reading journalists accounts.

  6. Just remember, in Casey Mulligan’s “world,” the representative agent trades with itself through time, renting its labor to perfectly competitive agents called firms, in turn for a unit good. In Casey Mulligan’s world, a benevolent dictator, the Walrasian auctioneer at the end of time, enforces transversality conditions and Euler equations. In Casey Mulligan’s “world,” what happened should not have happened. In Casey Mulligan’s “world,” there was a shock to technology in August 2007, in which people woke up on Monday having forget what they knew on Friday. In Casey Mulligan’s “world,” in December 2007, workers suddenly developed a strong preference for leisure and began to quit their jobs. In Casey Mulligan’s “world,” there is no cash, no credit, no finance.

    As a result, why would anyone In the real world care about Casey Mulligan’s “world?”

  7. TARP is wildly, extravagantly successful given its real purpose was to transfer YOUR money to bankers.

  8. As long as Casey Mulligan says what they want him to say, he will enjoy prestige, large paychecks, and unlimited job security. Not bad if you ask me.

  9. Discussing the ideas of Chicago economists is not a waste of time. It’s helps us formulate the strategy to destroy the world economy while enriching ourselves.

  10. Paulson said, “To restore confidence in our markets and our financial institutions, so they can fuel continued growth and prosperity, we must address the underlying problem.”

    See, Paulson really believed, apparently, that financial systems fueled growth. We now see it proven that this is simply BS. They have money, we have no growth. From that, it follows that his premise that saving the banks was essential is also BS… it was not, and is not essential.
    And, by the way, he never did address the underlying problem because he never understood what it was – also because of his incorrect view of how the world works.

  11. I do almost all of my banking at my local savings bank which converted from a mutual-owned to shareholder-owned bank a few years ago. When I look at their financial results, I see that they are essentially breaking even, even though they actually have a pretty good underwriting record. Based upon their posted rates, they clearly don’t want to do much mortgage business right now.

    Why are they doing so poorly?

    Because their FDIC premiums have shot through the roof. While the focus of this post has been big banks, I think that the market for loans has become much less competitive in the past 12 months because the smaller banks are being pushed to the brink and the non-bank origination has dropped to virtually zero (unless they can sell it to the government via Fannie, Freddie, or the FHA). Is this a legitimate thought?

  12. I kind of got a chuckle of the phrase “defy economic theory.” Really, the whole “housing and stock bubbles “defied economic theory.” Further, if neither finance or the shadow banking system served no economic function, and could disappear overnight with no effect on the “real economy,” why, under “economic theory” should they exist at all. Casey Mulligan is becoming Paul Krugman’s and Willem Buiter’s “strawman” by default for the “failure of modern economics.”

  13. Preserving the status quo, which is what TARP did, might not seem sexy and glamourous. But it appears to be all that our current dysfunctional political system was capable of doing in the fall of 2008, and certainly was preferable to the alternative — the collapse of possibly 40% of the nation’s banking system (if you look at asset ownership). That would have made the banking failures of 1932 look like a walk in the park, and the Great Depression look more like the Sorta Bad In A Minor Kinda Way Depression.

    That said, clearly something further needs to be done to get the banking system fully operational again. Preventing utter disaster was a worthy thing to do (although like many here I think the method chosen was far from the best way to do it), but now we need to move forward. Changes in the tax code to reward long-term investment rather than rent-seeking should end most of the abuses without excessive regulation (the easiest change: Raise the top marginal rates to what they were under that “socialist” Eisenhower Administration, but oh boy would you hear the screams from the rent-seekers!), but at a bare minimum something needs to be done about all the poison assets on the books of the major banks that are worth maybe 40% of what they’re currently booked at given declines in the overall real estate market. We are still in the midst of a solvency crisis, just one that’s not showing up on the books because of assets being booked at unrealistic prices. We may need another Resolution Trust Corporation here…

    Regarding Mulligan’s “economic theory”, his economic theory appears to describe a universe where cotton candy trees and unicorns exist. It describes no functioning economy in this universe, that much is for sure.

  14. Your wrong, the purpose is to increase lending. Why would we use taxpayer money for the sole purpose of keeping a failed bank around? Why because if it failed lending and thereby the economy would stop. Simply creating a government bank and lending out 700 billion would actually have succeeded in doing what we the taxpayer wanted.

  15. Mark, banks do one thing that you appear to not be factoring in: They create money via the action of fractional reserve lending. If banks simply disappear, they destroy money as they go down. The end result if you allow banks to simply disappear as vs. wind down their affairs in an orderly manner and transfer their assets to a more sound institution is that you end up in a deflationary spiral. Debts become unpayable because they were taking out in inflated dollars and are now being required to be paid back in more expensive deflated dollars. More banks collapse, causing more deflation, causing more debts to become unpayable. Wash, rinse, repeat, until the resulting money destruction brings us all back down to a barter economy like 1933 proved to be for much of the United States, or like most of the former Soviet Union in 1992 after the Soviet currency became worthless and turnips for a time became the monetary unit of exchange for most of the former Soviets.

    My grandmother remembered the county taking part of their crops in lieu of taxes and paying county employees with vegetables and cheese and sausage rather than money because nobody in the county had any money. This was in 1933. That is where simply allowing banks to collapse gets us. Nobody sane could propose that simply allowing banks to collapse is a reasonable or rational thing to do, we simply have too much historical data showing the end results, regardless of whatever demented theory says that works only in some universe where cotton candy grows on trees and unicorns are real. Have you seen a unicorn lately? No? ‘Nuff said.

  16. My knowledge of economics is obviously not all that great. With that in mind, could I ask a couple questions in regards to the aside about the toxic assets?

    1) Are they, as I suspect, truly hobbling the economy still and preventing a long term economic recovery so long as they sit on the books of the banks (or are overvalued in a government subsidy scheme to purchase them or are otherwise treated as anything other than a sick joke)?

    2) What would be the best (not for the banksters, but for ALL of us) way for those assets to come out of the economy?

    3) How will they most likely actually come out (because I’m sure there’s some way that’s good for banks and bad for the rest of us, and that’s what we’ll have foisted on us), and how different will the result be from the ideal scenario in question 2?

    I’ve been curious about those things lurking around for a while now. I really want to know what they’re ultimately going to do. Ever since I was a kid, I knew the longer you let a big problem sit, the bigger it got. I keep thinking these bankers and politicians that spanked them more often as children for running from problems instead of dealing with them.

  17. Right now the banks are hoping that the longer those assets sit on their books, the more they’ll be worth, because they’re hoping real estate prices will improve at some point in the future. But real estate prices are still above historic norms even at 40% of what they were at the peak of the bubble, plus as long as unemployment is rising there will be a shortage of qualified buyers who could drive prices up. Still, there’s one win-win situation where keeping those overpriced assets on the books could actually work: If the Federal Reserve and U.S. government cooperated in inflating the U.S. dollar at a rate of around 4-5% for five or six years. That would inflate the price of housing too, and result in eventually prices rising to the level of what the assets are valued at on the banks’ books.

    The problem is, that’s a very slow process, and in the meantime the banks aren’t lending so how are people going to afford to buy homes? This implies that significant financing needs to be given to Fannie/Freddie and Ginnie Mae via direct access to the Fed window and the maximum amount of a Fannie/Freddie/Ginnie loan raised (as well as their lending caps) so that mortgage lending can resume at near-normal rates. If the Fed is buying Fannie/Freddie/Ginnie mortgaged backed securities at a huge rate, this can get the housing market going again as well as contribute to inflation (since the Fed would be printing the money to buy these assets).

    In short: What the banks are hoping is that money will be printed. Inflation means debt deflation. Usually banks hate debt deflation because it hurts their profits, but right now with too much debt on their books that is unpayable at its current level, debt deflation is the least bad of the bad choices facing them since it will deflate the real value of their bad debts too. Inflation-caused debt deflation would also be good for consumers, since it would reduce the value of their debts and free up funds to resume consumption. Unfortunately this core monetarist observation is ironically opposed by exactly the same people who should not oppose it — monetarists who claim to be followers of Milton Friedman. But even Milton Friedman would have chided them as being short-sighted in this case — remember, Friedman is the person who coined the term “helicopter drop” to describe how the Federal Reserve should react if real interest rates approached the zero boundary (as they have done), all that “Helicopter Ben” Bernanke did in his famous helicopter speech was quote Friedman.

    So anyhow: That’s best case scenario as far as the banks are concerned — inflate the bad debts away. That avoids the mess of having to actually write them down as a loss. It would also be good for consumers. It also agrees with Keynesian theory, which says that the thing to do in this situation is inflate because inflation “primes the pump” so to speak by pulling investment money out from under (virtual) mattresses and puts it to work actually doing things that contribute to the economy. But it would be bad for bond holders including holders of U.S. Treasuries, who would see the value of their bonds decline in real terms. The question is, which of these parties has more pull in Congress right now? It is appalling that we even have to ask that question, rather than the question “what’s best for America?”, but that’s how our dysfunctional American political system works today — it’s all about who has more pull in Congress, not about what’s best for America (and for the world, for that matter).

    Right now, the bond holders are winning. The Chinese have bluntly told the U.S. to quit inflating the currency or they’ll quit buying U.S. Treasuries and indeed start dumping their Treasuries. But in any event this should clue you in on why the banks think it’s in their best interests to hold on to those assets rather than to split into “bad banks” and “good banks” — they’re still betting on Helicopter Ben being able to rev up his fleet of helicopters and getting inflation jump-started despite all the opposition to that from bond-holders, Republican legislators, and conservative Democratic legislators. Yes, that would decrease the value of their good debt, the properly valued debt, too…. which means that what their real books look like (rather than their public ones) must be scary indeed, with very little good debt to lose value.

  18. I always read Uwe Reinhardt or Simon Johnson’s column in NYT. Occasionally I spend 2 minutes drooling over Catherine Rampell’s bio picture. They have other economics writers at NYT?????

    Oh my……………………..

  19. Wow, that certainly explains a lot. Thank you! The only problem I see with the inflationary strategy (from the perspective of “The rest of us”) is that wages have been flat for a long time now. If I recall correctly that’s a big part of why the credit bubble happened; American consumers were encouraged to buy buy buy despite the gap between prices and real income, and credit was there to make up the gap. You say the inflationary strategy is win-win, yet if inflation continues its upward march at a FASTER rate while demand is still soft, I don’t see wages making up that gap. I see them falling behind even further, basically leaving us with less buying power.

    We’ll have the opportunity to pay down old debts with new less valuable dollars, but the incentive to take on new debts (especially for those newly disciplined about the use of credit by recent events) just seems minimal. The banks must TRULY be in awful shape as you’re guessing if they’d risk that, but besides allowing debt pay down what would the rest of us get out of it?

  20. This sounds right until you factor in the actual working of the banking system. What are the banks doing with all this free money? We can only tell by watching asset values. The banks appear to be fueling speculation in stocks and commodities and currencies, and the only borrowers seem to be hedge funds, and the hedge fund game continues to be arbitrage profits through maximum leverage, so what is happening, in all probability, is a repeat of 1998, with four or five hundred Long Term Capital Managements instead of just one. History tells us that one or two unexpected shocks will send the whole pyramid crashing down. The most likely shock is Chinese equivocation about funding the Treasury. But, of course, in a casino, damn near anything can happen.

    Meanwhile, in the real economy, you have too much excess capacity and still overinflated asset values, which means continuing job losses and attempts to create profits through cost cutting (more job losses) and a never ending parade of nitwit government leaf raking schemes to restart growth (all of which have their own designated beneficiaries whose determining characteristic is friends in high places).

  21. From a community banker’s perspective, regulatory Safety & Soundness exams have choked any new loan volume. This is not a bad thing as the industry moves through the credit quality cycle (again). The regulators are all looking at their own survival and want to be ahead of any failures to avoid the fate that OTS is bound to meet.

  22. Badtux:

    If banks and fractional reserve can’t be managed without the risk of catastrophe, maybe we should simply follow Mark’s advice and dispense with banks and fractional reserve?

    Seems simple enough to me.

    Otherwise, we can periodically bankrupt the country, and vaporize savings and investment while attempting to preserve fractional banking and banks-both systems that have proven to be failures and very dangerous.

    Query Badtux, do you know why the Canadian banking system, as in the one directly north of us, is ranked the #1 in the world…..?

  23. The problem with doing away with fractional reserve lending is that fractional reserve lending is the most effective way we have of financing investment needed to create future income using the income created by that investment. Without fractional reserve lending you are reduced to a situation where you cannot make investments to create future income until you somehow manage to scrape together enough money from current profits. But in a world where a semiconductor fab costs $5 billion dollars to build, that simply doesn’t work — the scale of infrastructure required for modern technology is too huge to be financed out of current profits, they have to be paid for out of the income generated by that infrastructure because otherwise that infrastructure never happens. We simply have no real alternative to fractional reserve lending, just as the scale of these investments also means we have no real alternative to limited liability corporations despite the many evils that they perpetrate (see The Corporation, film). What investor would take on $5 billion dollars in personal liability? It would be madness!

    Given that they (banks and limited-liability corporations) have proven in practice to be necessary evil, the proper response is to regulate them properly in order to make sure they behave properly. The biggest problem with the housing crash was that major portions of the cycle were not regulated properly. Bond rating agencies were regulated only haphazardly by state regulators, same deal with mortgage brokers, entire segments of the shadow banking system were totally unregulated, etc. Both major political parties are complicit in that situation because both have become victims of regulatory capture, so dependent upon income from the industries they are supposed to regulate that they wink wink nod nod at abuses rather than put an end to them.

    My understanding of the Canadian situation is that money is a much smaller component in Canadian elections. The Prime Minister stands for election only as a MP in his own district, not nationwide, Canada is 1/10th the size of the US population-wise, and Canadian elections are called on an irregular basis with maybe six weeks of campaigning allowed, rather than occurring regularly with years of expensive campaigning required to come out on top. The end result is that regulatory capture has not happened in Canada, and thus they are still effectively regulating their banking system.

  24. I would think the other alternative is just far slower growth. I know, I know, unacceptable to people that want everything NOW (i.e. most people in the first world today). I just wonder if our unquestioning belief that the furious pace of infinite growth people have right now is really a good (because it’s certainly unrealistic) idea in the long run.

    Granted, I think pondering a world with proper regulation OR no fractional reserve banking is simply an academic exercise anyway. Neither will ever happen. There’s too much power tied up in running unregulated/improperly regulated fractional reserve institutions for bankers to ever let go of their positions with a tremendous fight.

  25. Hey don’t laugh, it got him the Nobel Peace Prize. (OK, actually that wasn’t the official excuse.)

  26. There is no known mechanism for government spending, which adds money to the economy, to crowd out anything.

    Whether banks lend or not is wholly dependent on how good an investment lending is, compared with all the other investments a bank can make. It’s a business decision.

    Based on risk and reward a bank can decide to lend to consumers, lend to businesses, buy T-securities or participate in any number of other investment opportunities. This has nothing to do with “crowding out,” one of the most misused, misunderstood notions in economics.

    Rodger Malcolm Mitchell

  27. “Casey Mulligan also argues in a recent paper that the great recession was largely caused by increased preferences for leisure caused by disincentives to work, such as mortgage modifications and tax forgiveness plans”

    Damn. He’s on to me. I happily gave up my $200,000/year salary to live the good life on unemployment. Mulligan has his head so far up hi a$$ that he can see daylight!

  28. Government purchase of bank capital may actually _increase_ future private investment. Rather than ‘crowd out’ private investors, they signal that government has an explicit stake in various enterprises and will continue to support them.

    The real danger is not crowding out of investment, but misallocation. The banks that get government support are almost by definition the ones that were mismanaged. If private institutions decide to invest alongside the government, society may be doubling its bet on the worst-run banks, rather than reinforcing the strength of their better-run competitors.

  29. Here’s what the TARP was:

    Banks are quasi-public entities, that invest private capital and leverage it with public capital (FDIC insured deposits and Fed reserves) in order to allow private investment. This places banks in a “first loss” position, similar to the position you have when you put a down payment on a house.

    Since “live” banks can always borrow money, it is up to the banking regulators (FDIC and Fed) to determine if a bank has lost enough to go below it’s capital guidelines. Thus, banks don’t go “bankrupt” in the same way other business entities or individuals do, who can no longer finance their operation when they can no longer get money. (Banks can always “get money”) A bank failure is thus a regulatory determination, based on examination of it balance sheet.

    In the TARP, one federal agency (The Treasury) “bought shares” in the banks, changing numbers on their balance sheets so that another federal agency (The FDIC) could avoid having to declare them insolvent. The exact same thing could have been done by the FDIC simply changing or temporarily suspending it’s capital requirements. Note that the “exposure” of the Federal government is the same either way. (Of course, the FDIC also could have showed up at the Headquarters of these banks and informed the CEO that he was fired and that the banks were now the property of the FDIC, but that they would keep on operating as normal until the FDIC determined what it would do with them – but that sort of stuff doesn’t happen if you’re the CEO of Citibank and not the Bank of East Overshoe)

    Note, also, that the TARP was not, in actuality, an fiscal operation (the buying of goods and services, normal province of the Treasury) but a monetary operation: a swapping of reserves for other assets, similar to the Quantiative easing that the Fed has been doing. It did not, in fact “add to the deficit” at all, but it did convince the Congress and the general public (who have faced decades of misguided anti-deficit propaganda) that the deficit was $700 B bigger than it was, complicating the effort to pass the stimulus later.

    In no case did it having anything to do with giving banks :money to loan”: banks can always make any loan that meets the regulatory standards, without any need to “get the money” from anywhere else. As a matter of accounting, loans create deposits.

    In sum, it was a misguided, unnecessary policy carried out by people who had no understanding of the banking system (at least in the most charitable interpretation) and who are still at the highest levels of financial regulation in this country.

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