Let’s give three hurrahs to the big bank bailouts

Posted May 26, 2010, at 5:41 p.m.

Millions of Americans believe that the bank bailout was a huge mistake; they think it simply fattened bankers’ profits and provided few benefits to average Americans.

But in my view the bailout deserves three cheers.

Let me explain, starting with a comparison of the current recession and the Great Depression of the 1930s. During the first year of the current crisis, we were very close to an economic collapse on the scale of the Great Depression. In 2008, the Dow Jones stock index fell 34 percent, almost matching the 37 percent drop in 1929-30, the first year of the Great Depression. And in the first year of the current recession, U.S. industrial output fell by 12 percent, close to the 17 percent drop in 1929-30.

Fortunately, the similarity ends after the first year of the two crises. In the 1930s, after the disastrous first year, the economy just kept on worsening; in 1932, unemployment hit 23 percent. The economy didn’t fully recover for 10 years.

But in the current recession, the economy stopped worsening around the middle of 2009, and by the fall of 2009 we were seeing early signs of recovery. That fall, for example, the GDP started to rise after declining for four consecutive quarters.

Here’s the key question: why, in the current recession, did the economy start recovering after the first year, while in the 1930s it kept on declining year after year?

And here, in my view, is the answer: Because in late 2008, the U. S. Treasury and the Federal Reserve System took vigorous anti-recession actions. And the bank bailout was perhaps the most important.

Ben Bernanke, chairman of the Federal Reserve, and Henry Paulson, Secretary of the Treasury, both correctly believed that the deepening financial crisis — including the loss of confidence in the banks — was the critical element; that unless we stabilized the financial system, the rest of the economy would be driven into a multiyear decline, like that of the Great Depression.

Bernanke and Paulson had their hands full in early 2008, as the financial system came under increasing stress. But in September, with the complete failure of the big investment bank Lehman Brothers, stress turned into panic. In the following weeks, one corporate giant after another lurched toward failure.

At first, Bernanke and Paulson reacted to each potential failure like firemen, putting out one unexpected financial fire after another. Within weeks after Lehman’s fall, they organized rescues of the huge financial company AIG and several of the country’s biggest banks, including Wachovia. Just before Lehman fell, they had hastily organized the government take-over of mortgage giants Fannie Mae and Freddie Mac.

Though these steps were essential, they failed to restore faith in the biggest commercial banks. Bernanke and Paulson realized that they needed a proactive strategy. They decided to inject fresh capital into these banks, to assure the public that these key financial institutions would survive. They used the Temporary Asset Relief Program, or TARP, money Congress had wisely made available after Lehman’s fall.

At a critical meeting on Oct. 13, 2008, Paulson and Bernanke offered the biggest banks billions of dollars of new capital. Citigroup, JPMorgan Chase, and Wells Fargo each took $25 billion, while other banking giants took between $2 billion and $15 billion. Suddenly, it was clear that the big banks had plenty of liquid funds and that the government was committed to their survival. The public’s confidence in the banks started to rise.

The bank bailout, then, ensured that the financial system would not collapse and would not drive the rest of the economy into a multi-year nosedive. And it laid the ground for the recovery that began in the fall of 2009.

Admittedly, the bailout was ugly. For example, many people were rightly furious that some of the rescued banks awarded huge bonuses to their top staff members. But the bailout was absolutely necessary to save the banking system — and you cannot save the banking system without saving banks. The bailout, along with other bold actions by the Federal Reserve and the Treasury, probably avoided a second Great Depression.

What might have happened without the bailout and the other actions? During the current recession, unemployment hit a high of 10 percent, far short of the 23 percent rate of 1932. The difference between these two unemployment rates translates into a possible loss of 20 million additional jobs.

So shouldn’t we give three loud cheers for the bailout?

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

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