If you’ve followed financial news in the last year, the phrase “too big to fail” has probably entered your lexicon. “Too big to fail” and “too interconnected to fail” are measurements of risk. Both refer to the doctrine that the government should bail out a failing bank or business if its bankruptcy could threaten the entire system.
Banks are interconnected partly because they loan money to other banks. When one bank defaults, it can’t return the funds it borrowed, and the lending institutions, which were counting on being repaid, may go under as well. Moreover, if an especially large and trusted bank goes broke, depositors may lose confidence in the entire banking system and withdraw all their cash. The government may then face the option of propping up a faltering giant, or watching the nation’s banks topple one after the other like a line of dominos.
The decline of a major industry can also jeopardize the economy as a whole. For instance, the “Big Three” automakers, Chrysler, Ford and GM, were deemed “too big to fail” because millions of autoworkers, dealers and suppliers depend on them for work. The collapse of all three would have affected 1 in 10 jobs in the U.S.
There are good reasons to let doomed institutions fail. Banks and businesses can take undue risks if they can count on the government to save them from their own mistakes. And since the cash needed to bail out careless institutions comes largely from taxpayer’s pockets, banks and businesses can screw up with impunity, and we taxpayers foot the bill. Thus, the too-big-to-fail doctrine is at best the lesser of two evils—the greater evil being the kind of financial chaos that broke loose when Lehman Brothers was allowed to fail in September 2008.
Since last summer, the Treasury Department has allocated a total of $1.1 trillion taxpayer dollars to troubled institutions—$400 billion to Fannie Mae and Freddie Mac and $700 billion to the Emergency Economic Stabilization Act, also known as TARP or simply “the bailout.” ProPublica, an independent non-profit investigative journalism outfit based in Manhattan, provides a comprehensive guide to the bailout, including a complete list of who’s getting the money and how much. Some recipients are definitely out of danger. Wall Street’s mightiest brokerage firm, Goldman Sachs, received billions in taxpayer-financed TARP funds last fall, but posted $3.4 billion in profits from April through June of this year and promised its employees lavish bonuses. Goldman Sachs has paid back its TARP money, but as the jobless rate soars into double digits, it’s a grim irony that the richest investment bank and its employees are reaping the fruits of taxpayer dollars.
Many top officials want to stamp out the notion that big banks can rely on government largesse in troubled times. Federal Reserve chairman Ben Bernanke claims that he didn’t want to bail out financial giants, but his hand was forced. Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation (FDIC), has consistently questioned the bailout and said that abolishing the too-big-to-fail doctrine should be one of Washington’s chief economic priorities. A staunch defender of taxpayer interests, Bair was one of the few Republican officials who challenged the Bush administration’s deregulatory policies, which loosened government control of financial activities and thus permitted an epidemic of risky lending and unconstrained greed. But the GOP was not alone in championing deregulation. Since the 1980s, the vast majority of U.S. policymakers have preached free markets and consistently pressured other countries to let weak banks and companies die, with the rationale that this frees up capital for heartier competitors and strengthens the economy as a whole. In the U.S., there was the bailout of Chrysler in 1979 and the taxpayer-funded savings and loan bailout in 1989, but until 2008, the strategy of rescuing companies that were “too big to fail” was largely banned on American soil as an economic health hazard.
Although the government’s hands-off approach to finance and business has been touted as the key to U.S. economic strength, it’s worth noting that the financial giants didn’t grow rich and powerful simply because they were allowed to flourish in a free market. Rather, Wall Street executives got the government to give them more power (and less oversight) by showering politicians with monetary gifts. According to a report from the non-partisan Wall Street Watch Project, from 1998 to 2008, financial CEOs spent more than $5 billion ($3.4 billion on lobbyists and $1.7 billion on direct campaign contributions) to convince Congress members and presidents to trash Depression-era financial regulations. Harvey Rosenfield, the President of the Consumer Education Foundation, warns in the intro to the report that these same CEOs are still “pouring money into Washington to preserve their privileges at the expense of the rest of us.”
Many economists, policymakers and journalists have criticized the Obama administration for kowtowing to Wall Street. Obama’s financial regulatory plan, released on June 17, does little to deter risky lending. It doesn’t abolish the system that rewards executives for recklessness, and it doesn’t dismantle the sprawling financial bulwarks that received federal funds because they were “too big to fail.”
But should any financial institution be allowed to grow so big or interconnected that its failure could bring down the whole system? In the last ten years, a number of commercial banks, brokerage firms and insurance companies have merged to form “diversified financial conglomerates.” Many progressives are calling for Teddy-Roosevelt-style trust busting to break up the Wall Street behemoths and stop them from growing so powerful that they can push Washington around.
While there are excellent reasons to pare down conglomerates, it may be impossible to create a situation in which the government doesn’t have to worry about eminent financial institutions failing. The problem of banks being too big or too interconnected to fail is nothing new. In the 1930s, policymakers sought to regulate banks that were indispensable to the nation’s economic health, and in the late 1980s, officials fretted about savings and loan associations being too big to fail. Unfortunately, it may be impossible to create a situation in which the government doesn’t have to worry about eminent financial institutions failing. The problem of banks being too big or too interconnected to fail is nothing new. In the 1930s, policymakers sought to regulate banks that were indispensable to the nation’s economic health, and in the late 1980s, officials fretted about savings and loan associations being too big to fail. “As far as I know, there never was a time when policymakers could have viewed the collapse of a major money center bank with equanimity,” writes economist Paul Krugman in his New York Times column. “The point is that finance is deeply interconnected, so that even a moderately large player can take down the system if it implodes. Remember, it was Lehman — not Citi or B of A — that brought the world to the brink.”