Occupy Wall Street seem to oppose banker bailouts because bailouts are unfair. Bankers — by and large the most privileged class in society — got at the last count over $14 trillion of interest free money from central banks and governments to keep on doing the same thing — getting rich from speculation, on the backs of workers and the productive economy. The rest of society — teachers, nurses, factory workers, entrepreneurs, the unemployed, etc — have to “share the pain” of unemployment, austerity and a depressed economy.
This is particularly unfair, because it is the bankers and speculators who caused the crisis in the first place. But there is a much deeper economic reason to oppose bailouts than simple unfairness. Bailing out failed and failing financial institutions creates a zombie economy. Why?
In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.
These bailouts have tried to turn nature on its head — bailed out bankers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.
So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008. That crisis was caused by excessive financial debt. Wall Street banks do not just play with their own equity — they borrow huge sums of money, too. This debt is known as leverage — and many Wall Street banks in 2008 had forty or fifty times as much leverage as they had equity. The problem with leverage is that while successful bets can very quickly lead to massive profits, bad bets can very quickly lead to insolvency — a bank that leverages itself 50:1 only has to incur a 2% loss on its portfolio to have lost every penny they started with. Lehman Brothers was leveraged 30:1.
Following 2008, many on Wall Street promised they had learned their lesson, and that the days of excessive leverage and risk-taking with borrowed money were over. But, in October 2011, another Wall Street bank was taken down by bad bets financed by excessive leverage: MF Global. Their leverage ratio? 40:1.
So why was the banking system bailed out in the first place? Defenders of the bailouts have correctly pointed out that not bailing out certain banks would have caused the entire system to collapse. This is because the global financial system is an interconnected web of debt. Institutions owe huge sums of money to one another. If a particularly interconnected bank disappears from the system, and cannot repay its creditors, the creditors themselves become threatened with insolvency. If a bank is leveraged 10:1 on assets of $10 billion, then its creditors may incur losses of up to $90 billion. Without state intervention, a single massive bankruptcy can quickly snowball into systemic destruction.
Ultimately, the system is extremely fragile, and prone to collapse. Government life-support has given Wall Street failures the resources to continue their dangerous and risky business practices which caused the last crisis. Effectively, Wall Street and the international financial system has become a government-funded zombie — unable to sustain itself in times of crisis through its own means, and dependent on suckling the taxpayer’s teat.
The darkest side to this zombification is that it takes resources from the productive, the young, the creative, and the needy and channels them to the zombies. Vast sums spent on rescue packages to keep the zombie system alive might have been available to increase the intellectual capabilities of the youth, or to support basic research and development, or to build better physical infrastructure, or to create new and innovative companies and products.
Zombification kills competition, too: when companies fail, it leaves a gap in the market that has to be filled, either by an expanding competitor, or by a new business. With failures now being kept on life-support, gaps in the market are fewer.
The system needs to change.
As Professor George Selgin of the University of Georgia put it:
Our governments chose to keep bad banks going and that is why quantitative easing has proven a failure. Quantitative easing failed because almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers. Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.
It’s the same scenario that Japan has experienced for twenty years. They experienced a housing and stock market crash in 1990, bailed out their banking system, and growth never really recovered:
Ever since then, unemployment has been elevated:
That is the fate that Britain, Europe and America face by going down the Japanese zombification route: weak growth and elevated unemployment over a prolonged period of time. They face having the life sucked out of them by the zombie banks and corporations, and the burden of an every-growing public debt to finance more and more bailouts:
Instead of bailouts, we need to allow failed banks and corporations to fail and liquidate so that new businesses can take their place. Nature works best through experimentation. Saving zombie banks and zombie corporations kills experimentation, by rewarding failure, and preventing bad ideas from failing. If bad ideas and schemes cannot fail, it is impossible for good ideas and schemes to truly succeed.
The role of the government should be to provide a level playing field for experimentalism (and enough of a safety net for when experiments go wrong) — not pick winners. If experiments go badly, that is no bad thing: it just means that another idea, or system, or structure needs to be tested. People should be free to go bankrupt and start all over again with a different mindset and a different idea.
Great article Aziz, The main problem is big business has the politicians in their back pocket, and many CEOs are protecting their jobs. If Corporations were banned from political donations, and graft and corruption was policed, Governments would not be held hostage to banker demands.
Maybe we need a new reality series. “Bernanke Island” Where society learns economics in a fun and brain dead way. Just like Dancing with the stars.
Like I said before, perhaps we all need to go back to studying Tribal Economics. Our great Economists had their experiences based on complex Industrial economies, so had to develop simple models to understand. How many went to Islands to study real world models where some people were industrious, and others freeloaders? How many saw the effect of imports and exports on the industrial base of the Island.
Your analogy with harvests is correct. If you don’t understand your environment, your input factors and your labour costs, how can you supply a market. If you misjudge the market need you receive a lowerprofit.
I don’t know how you do it. Churning out all these articles. It depresses me just thinking about the issues the world has itself in. Perhaps I will read a book. Brave New World. That will cheer me up.
This article was written for a general, non-technical audience in a friend’s publication, Buddy. Once I have a link I will link to it.
If you think I am prolific, Tyler Durden isn’t just prolific, he’s scary. He must write 20 posts a day. Krugman sometimes writes 4 or 5. I know they both probably have people to help them, and I am a one man team.
Hey, I thought it was a well-known fact that Tyler Durden is a group of people posting under anonymity ( http://en.wikipedia.org/wiki/Zero_Hedge ).
Your gifts are rarely without profit.
Today’s wisdom, however, may be your best effort.
Thanks. I put a lot of work into it.
In my opinion these articles are my best:
And my personal favourite:
So what are you going to do about it, Aziz? Alas, the same as the rest of us, i suppose.
That two democracies have had their leaders replaced by the undemocratic EU, should have people rioting in the streets, but i’ve seen not so much as a shrug of the shoulders.
That countries such as Australia, USA, Canada and in Europe are low on the corruption index is mind-boggling. How there could be countries many times more corrupt than ours is breathtaking. The problem is that a whole range of ‘win-win’ scenarios have been created between governments and organisations, which conveniently ignores the fact that in such win-win scenarios, the masses get screwed. It’s two lions and a sheep voting for who gets to be breakfast.
What am I doing?
Attempting to explain in clear, simple language what the problem is, and why zombie economics is so very, very bad for everyone concerned.
I suggest anyone with a basic understanding of the problems does the same thing.
Eventually, we can reach critical mass.
Well said. How do paradigm shifts happen? Someone has an idea and tells two friends, and they tell two friends, and they tell two friends…
In this case, rather than super-fresh smelling hair, we want an end to bailouts, and an end to zombification. Tell two friends; tell them to tell two friends; and so on.
Apologies for being confrontationalist. You are indeed educating and well supporting your arguments. I’m just overwhelmed at the lack of political effort to do what clearly needs to be done. Australians are grossly apathetic. Most are too busy working their arses off making money to worry about such injustices. It’s a case of “they’re a bunch of meddling communists but we’ll vote them out next election”. But what if they regulate the Murdoch press to report only on gossip, and set up their own “government funded independent” newspaper like Bob Brown is pushing for? They use the UK scandal as an excuse to have a media enquiry here, to shut up the Murdoch press, while furthering the change of our public broadcaster to a far left propaganda machine. Criticism of the Carbon Tax has already been muted voluntarily by the Murdoch press after a personal phone call by the prime minister. Greens policies that were laughed at a year ago are becoming law, and the Liberals are too full of lawyers and bankers to resist what really matters. A year ago I thought my mother was being hysterical about such matters, but it appears to be coming real before my very eyes.
I love your work, Aziz. I’m just being the devil’s advocate.
I don’t know much about Australian politics (though Julia Gillard scares the living daylights out of me) but what I think you’re saying illustrates the futility of politics without a tidal wave of consciousness to back it up.
The vast majority of people won’t wake up to anything until their material prosperity is threatened. Now, while this will soon be happening worldwide (oil shock, Iranian war, Euro meltdown) I would say Australia is probably one of the least threatened nations in that regard…
The best hope is to telling friends, and two friends, and two friends, etc.
Mass consciousness. Politics will come in its own time.
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Nice article , I would imagine that bailouts are more political than the economic sense they try to make out of it, no one wants to be in power when the chain of failing banks fail and the misinformed electorate blames it on them. You think bailing them out and prohibiting them from carrying out similar actions through regulation is a wise step?
No I think it’s a bad idea because it kills competition and experimentalism, and as the repeal of Glass-Steagall proves human regulatory regimes are corruptible. If the political system is captive to the idea that “the banking system must not fail” then it will fail too. Politics cannot legislate away reality.
Upping the regulation ante just causes greater effort to get around the regulation by ever more complex means.
If the US government can break up Microsoft, it can break up the big banks so they are small enough to fail.
In Australia, political parties receive government funding based on proportion of votes received, but only after an election. So in the interim, they must approach banks for funding for their election campaign. How do you go to an eke tion on a platform of reducing bank power when you need them to lend you money for that purpose?!
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Great post and comments! (You’all)
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Your analysis of zombification is a little superficial. Even if the TBTF banks were allowed to perish, the problem of public debt will remain. Allow me to explain:
In a free economy, the growth of the money supply, m’/m = i, the interest rate. Market forces govern the interest rate so that i’ = -(i(t) – r(t)) which is to say that the instantaneous interest rate wants to converge to the real interest rate r = Q’/Q. Whenever i’ ≠ 0 there is temporary inflation/deflation due to an excess/shortage of money and prices rise/fall as a result.
In a socialist/mixed economy, m’/m = i+ g where g is the annual growth of public spending which causes there to be an excess of cash deposits in the bank relative to the real output of the economy. In this case i’ = di/dt = -(i+g – r) so that the market interest rate converges to r-g < r so that there is under investment in the real economy.
Also, i = V(1-u) where u is the wages share of output so that V = i/(1-u) and
V' = -(V(t) -i/(1-u)) so with i and u continuously falling, V is falling as well causing, among other things, declining real wages, loss of purchasing power which make the US Dollar a piece of crap.
It's too soon to say whether the Icelanders can reestablish a sound currency but just ditching some speculating banks doesn't seem like enough to me. The public debt needs to be paid off as well.
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Close but not quite.
Debt is not valid in the legal sphere when the contract is not voluntary vis a vis the relevant parties. After all, could I sign you up to some debt without your consent? No, of course not – that would be anarchy!
So some governors can rack up debt in the name of “their nation” and then point towards (being on the winning side of) democracy – the otherwise fair idea majority rules – to inturn ‘legitimize’ their desire to act against the Law (by signing up various people onto some amount of invariably international debt to which they never personally consented – through signature, for example – even if they DID vote for the signer of said debt).
Let’s have a thought experiment, instead:
In a sub-optimal economy with artificial interest rates, a disproportionate number of (“expert”) people govern a group of very important interest rates, but this has the potential to end up producing unintended consequences. Fortunately, one of said consequences is to focus the (global) mind on the particular problem so a peaceful solution (to this theoretical issue) is quite likely 🙂
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