I think liberals are committing a conceptual mistake touting how much money was made as a result of the TARP fund. (I think it’s also a political mistake, but I’ll leave that aside.) I really liked Ryan Avent’s argument that, as long as the government didn’t collapse, it isn’t hard short-term to make money on an oligarchy when the government puts its full weight behind it:
It’s not hard to do well on investments like those the government made in the big banks and in GM. Where the banks were concerned, the government received shares at prices reflecting market fears that failure was imminent. Having made the decision to stand behind the firms, the government made clear that failure was not imminent. Share prices then recovered, and they rose still further as the crisis atmosphere gave way to economic recovery. If you can buy a company on the ropes and guarantee that it won’t fail, then you’re sure to make money. Indeed, quite a lot of people insisted at the time that the government would make money…
Take any business and extend to it a government guarantee against failure and its value will increase. Now, it’s fine that the government convinced markets that it wouldn’t allow the banks to fail; that was the whole point of the legislation. But having convinced markets that the banks won’t be allowed to fail, the government has accepted some set of unknown future obligations, which are growing all the time thanks to the moral hazard of the government guarantee. It could take itself off the hook for these obligations by credibly demonstrating that it would allow banks to fail in the future, but it hasn’t come close to doing so. The too-big-to-fail banks are bigger than ever, and the regulatory reform law didn’t come close to setting up a framework through which a large, complex, international firm could go down in a period of crisis.
I’d argue it a different way. The way I explain it to myself is that we should think of a financial crisis as a three step process. First, there is a liquidity event, where the logic of the system can’t hold, the equilibrium switches to a “panic mode”, and in the flurry nobody can tell a solvent firm from an insolvent firm. The government, if credible and if it has the right tools, can step in to stop the panic. The emergency lending facilities and TARP constituted our policy reaction to the liquidity event.
To me the evidence is strong that there was a liquidity event in fall 2008 greater than than underlying solvency crisis, and whether or not TARP was the best approach to the situation, it was successful in stopping a shadow banking run.
The second step is a solvency event. There are bad debts out there, and they need to be sorted and written down. The system is calmed, and our new objective is to figure out the functioning firms from the zombie firms, splitting out good banks from bad banks. The policy responses here was the Public-Private Investment Program (P-PIP), also known as the “Geithner Plan”, which used FDIC as a backstop to pay hedge funds to buy toxic “legacy” assets, assets whose profits would be split with Treasury. This was largely abandoned, and in its place was the stress tests of early 2009 which gave an all-clear.
The last step is a reform event. Whatever tools were necessary to stop the panic needs to be formalized and held accountable. What was broken in the acts of maturity transformation, leveraging and transferring capital from lenders to borrowers need new regulation to remove agent and informational problems. This was the Dodd-Frank Act as well as the international regulation procedures, including Basel III.
These need to move together. Without subsequently handling the solvency issue after a liquidity event it does nothing to fix the sluggish growth and bad debt that hangs around the economy now. And without a strong measure to regulate the shadow banking sector all you’ve done is create moral hazard for the biggest players.
So it doesn’t matter if TARP makes a ton of money. TARP is only one of three parts of what needed to be done, and to view it in isolation from, say, the stress tests, misses the forest for a tree. If this was misjudged, then no amount of TARP payouts is going to cover the fact that Bank of America and Citi will only get solvent by squeezing every penny out of the bad debt of Americans for the next decade, killing growth and churning deadweight losses for everyone else. And then they’ll do it again.