Quick Comment on Optimal Bailout

September 23, 2018

I have repeatedly said over the last few weeks (and ten years) that bailing out the banks was not necessary to prevent a second Great Depression. While I think this is absolutely true for reasons I have laid out many times, let me make a couple of additional points.

I think a bailout that imposed stringent conditions on the financial industry, essentially requiring a downsizing and restructuring, would have been better than just letting the banks fail. That would have been the best possible outcome. But given that this sort of bailout was not on the table, I think no bailout would have been a better option than the one we got, which largely left the structure of the industry intact.

Also, I have no doubt that the downturn in 2008–-09 would have been worse if the banks had been allowed to fail. But I think the short-term pain would have been more than compensated for by eliminating the albatross of a bloated financial sector. A downsized financial sector would have freed up tens of billions annually (perhaps more than a hundred billion) for productive uses like education and health care. It also would have eliminated a major driver of inequality in the economy, since many of the highest incomes in the economy are generated by the financial industry.

Of course, the idea of having more short-term pain, which I would likely not experience, is not an argument to be made lightly. If the unemployment rate had risen by another half or full percentage point due to the failure of the banks, that means millions more people would be suffering as a result.

That is a very bad story, but one that economists often advocate under other circumstances. Specifically, any economist who has ever advocated that the Federal Reserve Board raise interest rates is effectively making the short-term pain for long-term gain argument. Usually, the case for higher rates would be that preventing spiraling inflation and the associated costs are worth the job loss (or slower job growth) that will be associated with the Fed’s rate hike. 

In both the case of letting banks collapse and a Fed rate hike, people can have reasonable differences on the terms of the tradeoffs and therefore come to different conclusions on the best policy. But any economist who argues that we had to bail out the banks because any additional short-term pain was unacceptable, does not deserve to be taken seriously. 


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