The Great American Bank Robbery, Part II

The following is Part II of a two-part excerpt from Freefall: America, Free Markets, and the Sinking of the World Economy by Joseph Stiglitz (W.W. Norton & Co., 2010). Click here for part I.

The U.S. government should have played by the rules and "restructured" the banks that needed rescuing, rather than providing them with unwarranted handouts. This is so, whether or not in the end some of the banks manage to pay back the money that was given to them. But both the Bush and the Obama administrations decided otherwise.

As the crisis broke out in late 2007 and early 2008, the Bush administration and the Fed first veered from bailout to bailout with no discernible plan or principles. This added political uncertainty to the economic uncertainty. In some of the bailouts (Bear Stearns), shareholders got something, and bondholders were fully protected. In others (Fannie Mae), shareholders lost everything, and bondholders were fully protected. In still others (Washington Mutual), shareholders and bondholders lost nearly everything. In the case of Fannie Mae, political considerations (worrying about earning the disfavor of China--as a significant owner of Fannie Mae bonds) seemed to predominate; no other good economic rationale was ever presented. Though there was often some reference to "systemic risk" in explaining why some institutions got bailed out and others didn't, it was clear that the Fed and the Treasury had insufficient appreciation of what systemic risk meant before the crisis, and their understanding remained limited even as the crisis evolved.

Some of the early bailouts were done through the Federal Reserve, leading that body to take actions that were totally unimaginable just a few months before. The Fed's responsibility is mainly to commercial banks. It regulates them, and the government provides deposit insurance. Before the crisis, it was argued that investment banks didn't need either access to funds from the Fed or the same kind of tight regulation, since they didn't pose any systemic risk. They handled rich people's money, and they could protect themselves. But all of a sudden, in the most munificent act in the history of corporate welfare, the government's safety net was extended to investment banks. Then, it was extended even farther, to AIG, an insurance firm.

Eventually, by late September 2008, it became clear that more than these "hidden" bailouts through the Fed would be required, and President Bush had to go to Congress. Treasury Secretary Paulson's original idea for getting money into the banks was referred to by its critics as "cash for trash." The government would buy the toxic assets, under the Troubled Asset Relief Program (TARP), injecting liquidity and cleaning up the banks' balance sheets at the same time. Of course, the bankers didn't really believe that the government had a comparative advantage in garbage disposal. The reason they wanted to dump the toxic assets on the government was that they hoped the government would overpay--a hidden recapitalization of the banks.

The real tip-off that something was awry came when Paulson went to Congress and presented a three-page TARP bill giving him a blank check for $700 billion, with no congressional oversight or judicial review. As chief economist of the World Bank, I had seen gambits of this kind. If this had happened in a Third World banana republic, we would know what was about to happen--a massive redistribution from the taxpayers to the banks and their friends. The World Bank would have threatened cutting off all assistance. We could not condone public money being used in this way, without the normal checks and balances. Indeed, many conservative commentators argued that what Paulson was proposing was unconstitutional. Congress, they believed, could not walk away so easily from its responsibilities in allocating these funds.