A bailout is the worst option, except for all the others.
The old saw about democracy is that it’s the worst form of government, except for all the others.
At the moment, the same holds true about bailouts aimed at averting economic panic — like we saw with Silicon Valley Bank (SVB) this weekend.
There is semantic dispute about whether the US government’s guarantee that SVB deposit holders (including Vox Media) will get all their money back rather than just the $250,000 per account protected by law, or a new lending facility that other banks can draw from to stave off problems, qualifies as a bailout. President Biden denies the term applies, and there are differences from the much-loathed 2008 bailouts. It’s a free country and you can call it a “rescue” instead if you wish, but I’ll stick with bailout for simplicity’s sake.
The point is that most people in the political system profess to hate bailouts. Many on the right denounce it as suspect government intervention in the free market. Many on the left view it as a sop to rich fat cats and complain that ordinary people facing financial hardship get no such special help. The beneficiaries, whether they’re irresponsible Wall Street bankers or arrogant venture capitalists, are often unsympathetic. The whole thing just feels so wrong.
But it keeps happening. And there’s a very simple reason why, and it’s not corruption. Policymakers think the alternative, of letting the institution in question fail without special intervention, would be much worse and do a whole lot more damage because of panic-driven “contagion” spreading elsewhere in the economy — damage that really does not need to happen.
Back in 1991, Jerome Powell had just started work at the Treasury Department when the Bank of New England, the 33rd largest in the country, was about to fail. Nick Timiraos recounts what happened next in his book Trillion Dollar Triage.
One adviser argued that a bailout for depositors would create “moral hazard,” enabling more irresponsible behavior and that they needed to lose at least some of their money. A Fed governor then responded:
Here’s what we think will happen if we haircut uninsured depositors. There will be a run on every American bank when they open Monday, and all these money-centered banks will be at our door. Do you really want to run that test?
Spoiler: They did not want to run that test.
Bailouts like these are typically an attempt to stop unnecessary further damage to the economy — damage that doesn’t need to happen, but could if people start panicking a little too much. Larger structural reforms could in theory prevent at least some bailouts from becoming necessary, but in the moment, there’s rarely a better option available.
The logic — and illogic — of bank runs and economic contagion
Bank runs and economic panics are a combination of rational and irrational behavior.
The rational parts of the run on SVB were that, yes, the bank’s books did have real problems, and, yes, any individual depositor’s interests would have been best served by withdrawing funds.
The irrational part was that, per Bloomberg’s Matt Levine, SVB “could probably have muddled through and been profitable if people had just kept their money in the bank.” But once concern about SVB started to spread among VCs and founders talking on Slack and WhatsApp, it became a self-fulfilling prophecy as everyone tried to pull their money out at once.
The logic of government intervention is to restore confidence in the financial system — to convince people that they don’t need to panic and that panic is not actually the rational option. This weekend’s bailout was effectively a message to depositors at other regional banks that they’ll be fine and that there’s no reason to flee for the exits.
The ugly logic to this was also on display this weekend — before they hand out a bailout, policymakers have to be convinced there actually is a risk of panic-fueled contagion to the financial system. So, over the weekend, while angling for a bailout, several VCs fervently stoked fears of a nationwide bank run that they claimed would ensue if SVB deposit holders weren’t made whole.
YOU SHOULD BE ABSOLUTELY TERRIFIED RIGHT NOW — THAT IS THE PROPER REACTION TO A BANK RUN & CONTAGION @POTUS & @SecYellen MUST GET ON TV TOMORROW AND GUARANTEE ALL DEPOSITS UP TO $10M OR THIS WILL SPIRAL INTO CHAOS
— @jason (@Jason) March 12, 2023
Some scoffed at these claims, calling them irresponsible as well as obviously self-interested. They were obviously self-interested — but that doesn’t mean they were wrong.
The logic — that, if it remained unclear that depositors’ money in small and mid-size banks would be protected, they’d likely flee to the safety of “too big to fail” banks — seemed compelling. We can never know the counterfactual for certain, but small-bank stocks had a rough day in the markets Monday even after the bailout happened.
It’s also tough for policymakers to know for sure just how bad things will get in advance if they opt against a bailout. After the US government decided to let Lehman Brothers fail in September 2008, the New York Times editorialized that the decision was “oddly reassuring,” suggesting that “the system may be strong enough absorb” its collapse, and praising regulators for finally being “willing to hold Wall Street accountable for its mistakes.”
The system was not strong enough. Two weeks of financial market chaos ensued until Congress finally agreed to pass the Troubled Asset Relief Program (TARP). The program became infamous as the $700 billion bank bailout, and populist politicians have trashed it for years. (Some $426 billion ended up being spent, and years later the government made $441 billion back, actually making a profit on it in the end.)
So in the moment, the logic for a bailout is often compelling — or at least more compelling than not doing a bailout. But there’s still something unsettling about the whole dynamic that cries out for larger reforms, as the journalist Matthew Klein summed up in a recent Substack post.
“Banks are speculative investment funds grafted on top of critical infrastructure,” Klein wrote. “This structure is designed to extract subsidies from the rest of society by threatening civilians with crises if the banks’ bets are ever allowed to fail.”
The US government’s response to SVB’s failure “is a reminder that those threats usually work.”
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