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Did The Bank Bailout Work?

March 18, 2010 63 comments

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By Marquis Codjia

A few months ago, the crumbling global economy was atop the agenda of many G20 leaders. Social unrest, banking sector meltdown, global growth conundrum, and stock market yo-yos were the main discussion topics among the planetary leadership.

Governments the world over addressed the most imperative issue, the banking pandemonium, with massive cash inflows into a sector that hitherto epitomized capitalism at its best (and worst), with a modus operandi more akin to central intervention in communist economies.

The global tab ranges from 4 to 5 trillion US dollars according to the most optimistic estimates, but the overall costs may run higher in the future.

The financial rescue of the ailing banking sector, in principle, was the right course of action and various experts across the political spectrum saw eye to eye on its criticality, including the staunchest free-market theorizers who routinely treat as leftist energumens out of the antediluvian era those who dare buck conventional wisdom regarding the role of government in social economics.

It was flummoxing, however, to observe how lenient authorities were vis-à-vis banks throughout the bailout process on top of the very favorable terms under which funds were disbursed. Hence, financial institutions that benefited from state largesse were able to quickly use monies received to regain profitability and reimburse their respective governments.

Other parts of the economy didn’t experience so swift a recovery. Unemployment is still high; the mortgage sector is still in a shambles. Banks have been reluctant to lend, creating an underperforming productive sector and a lethargic private consumption. The stock market may be up but, debatably, the “real economy” is still down.

Banks played a crucial role in the current economic malaise, but anti-bailout commentators were wrong to vilify them and to affirm that such guilt should have precluded public rescue. Financial intermediaries are an epochal pillar of our post-modern economies, and it would have been socio-economically ruinous and politically unpalatable to let them sink.

Admittedly, a majority of banks are today more cash awash and profitable than a year ago albeit some pockets of the industry are still comatose owing to the liquidity hemorrhage that has devastated them since the recession erupted.

Regrettably, nothing has changed. These institutions are resorting again to the erstwhile practices that wrought havoc to the economy in the first place, under the aegis of a regulatory body eerily blind, deaf and tongue-tied.

Banks, evidently, should be encouraged to pursue and make profits as any private concern. But when such a financial quest comes at the expense of an entire system or poses a systemic threat to the productive sector of the economy, the argument in favor of tougher regulation becomes of preeminent import.

Companies need to utilize hedging for exposure control; yet, speculators lately seem to use derivatives to bet against their very benefactors. Although outrageous to vast swaths of the populace, such practices are explicable if one considers that the speculating camp only furthers private interests of elites (their investors) who seldom factor morality into the profitability equation.

Case in point: Greece. The Hellenic government bailed out its banking sector with billions of dollars only to see their country downgraded a few months later because of a perceived default risk.

At this moment, elected officials and central bankers should ponder the following question: did the bailout work? Or, stated differently, did the mammoth cash infusion into banks and the associated supplemental initiatives reach the initial goals?

Seasoned economists and social scientists will grapple amply with issues regarding program effectiveness and efficiency in the future, but prominent experts currently believe the answers to such interrogations are negative. George Mason University economist Peter Boettke posited that bank bailouts have created a “cycle of debt, deficits and government expansion” that in the end “will be economically crippling” to major economies, whereas Barry Ritholtz, famed author of Bailout Nation and CEO of research firm FusionIQ, thinks the rescue programs could have been conducted better.

It can be argued that the initial rescue phase of the bailout program was effectual in that it helped avert a domestic and global banking hubbub. But, contrary to popular credence, that was the easiest part. The courageous headship of political leaders and regulators cannot be underrated in the process, but it is indisputably far facile for a powerful central bank, like the US Federal Reserve, to make journal entries to the credit of targeted institutions and replenish their corporate coffers via the much celebrated “quantitative easing”.

The Fed, just like other G8 central banks, is in an enviable position because it can create money ‘out of nothing’ by increasing the credit in its own bank account. Ask current Greek Central Bank governor George Provopoulous whether he’d like to have such latitude.

Regulation is where actual political bravery need be shown from authorities, and so far the lack of sweeping reforms in the financial sector may obliterate the latter’s plodding recovery.

At present, there are five distinct reasons explicating the mediocre results obtained so far from the bailout scheme.

First, the much needed financial overhaul is taking longer to move up the legislative ladder and reach US President Barack Obama’s desk because not only financial lobbies – such as the über-powerful American Bankers Association – are exerting strong pressure,  the political agenda is also crowded out with the pressing healthcare reform and the geostrategic concerns linked to conflicts in Afghanistan and Iraq.

The fact that Senate Banking chief Chris Dodd, D-Conn., wants to introduce reform in the sector will probably change little in the short-term.

Second, President Obama’s own senior level financial staff is composed of former Wall Street alumni and lobbyists, and many skeptics are incredulous that a clique so tied to financial interests can spearhead true reforms in an industry that was previously munificent to them.

The next two factors are endogenous to the banking industry. One is the past experience of regulation and deregulation cycles that usually make laws dissipate over time, and the other stems from the idiosyncratic ability of financial engineers and investment bankers to design new products and techniques to counter existing laws.

Finally, the regulatory endeavor should be global in scope, and the present lack of geographic cooperation and the practical difficulty to track systemic risk within the industry are currently handicapping further advances.

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