Daniel W. Drezner

Why the political extremes might save the U.S. financial system

Why the political extremes might save the U.S. financial system

The Troubled Assets Relief Program expired yesterday. I’ve blogged about how this program was both cost-effective and a pretty significant policy achievement. This appears to be the expert assessment as well. The Wall Street Journal‘s Deborah Solomon and Naftali Bendavid explain:

It will ultimately cost far less than the initial $700 billion price tag that stunned a nation. Major banks are profitable and can raise capital. Credit spreads — a key measurement of risk — are down to pre-crisis levels.

The White House now projects TARP will lose at most $50 billion, down from $105 billion projected earlier this year. Privately, Treasury Department officials say the U.S. may not lose a dime, and could ultimately make money depending on how some investments fare, in particular American International Group Inc. and General Motors Corp. In a $14 trillion economy, $50 billion is less than 1% of economic output.

"The incredible irony here is that TARP probably succeeded wildly beyond anybody’s imagination," said Alan Blinder, a Princeton University economist who co-authored a paper crediting the administration’s economic policies with preventing a second Great Depression. "Suppose the original TARP bill had been to spend $50 billion to avert a catastrophe. Would anyone have blinked?"

Or consider the Financial Times story by Tom Braithwaite:

[A]ll of the consequences have to be judged against late 2008 and early 2009 when fear stalked the markets and nationalisation of the biggest US banks looked a possibility.

Making a play on a famous MasterCard commercial, Mr [Lee] Sachs outlines what the country got in return for its investments in the banks. “Dividends? Five per cent. Equity warrants? Two per cent. The economy not turning into the second Great Depression? Priceless.”

Despite this fact, however, TARP is ridiculously unpopular with the American people. 

Oddly enough, this might be a very good thing, for two reasons. First, the likelihood that the latest financial reform bill will prevent a future financial crisis is exactly nil. There will be moments down the road when the financial sector will come crying to Washington.   

TARP’s biggest problem, however, was that it badly exacerbated the moral hazard problem. If banks know that they are insured against catastrophe, this gives them an incentive to act in a more risk-loving manner to maximize profits — thereby increasing the probability of a catastrophe. While this might be a good thing in some sectors of the economy, finance is not one of them. 

TARP’s political unpopularity, however, could help to eliminate the moral hazard problem. As Solomon and Bendavid observe: 

Perhaps the biggest fallout from TARP is that it precludes another TARP. Should the financial sector run into trouble, the chances of another government bailout are essentially nil. For many on Capitol Hill and beyond, the end of bailouts is a good thing. But some worry TARP’s legacy could be a more devastating financial crisis down the road.

"The greatest consequence of the TARP may be that the government has lost some of its ability to respond to financial crises," concluded the Congressional Oversight Panel, which oversees TARP and has been one of its biggest critics.

Now, truth be told, I’m not sure this is entirely accurate. Sure, rescue packages are unpopular now — but let the Dow Jones Industrial Average fall 800 points and politicians might react differently. If, however, the political perception is that no more bailouts from D.C. will be forthcoming, then it might condition financial players to act in a more prudential manner.

In other words, the Tea Party activists on the right and the netroots activists on the left might be the political lobbies that do the most to preserve the integrity of the U.S. financial system. 

I’ll be spending the rest of the day savoring this irony. I welcome commenters trying to burst my cognitive bubble, however.