Over at Anti-Dismal Paul Walker says:
The bailouts were not a good idea, just think of the moral hazard problem this has created, while there may have been more justification for the Fed acting to prevent the money supply from falling.
These are all important issues. If the “bailout” (I use the term loosely, as buying profitable equity shares and making loans that get paid back are not what we normally view as a bailout) created a moral hazard problem we are just delaying an inevitable contraction – and supporting inefficient firms. Furthermore, if there is another way for the Fed to control the money supply without a bailout it is likely that would be a preferable action.
However, the fact is that a bank run (which is what we were trying to prevent with the “bailout”) reduces the money supply – even if the Fed leaves the money stock unchanged. As a result, we can’t really treat the two issues separately. Remember, the Fed doesn’t control the money supply directly, the money supply is formed through the financial system. As a result, I don’t think that the Fed could “maintain the money supply” in the face of a massive bank run.
In regards to the 1930’s this point is illustrated by Bruce Bartlett (ht Marginal Revolution):
There’s no way the Fed could have expanded the money supply in the early 1930s without bailing out the banks. How do you think the money supply declined in the first place? It’s because banks failed and their deposits disappeared. To keep those deposits from disappearing in an era before deposit insurance would have required keeping bankrupt banks afloat.
If we had experienced a bank run, we would have suffered a similar decline in the money supply – even with the Fed pumping money out into the money stock. Now if prices cleared perfectly this wouldn’t matter, the drop in “velocity” would be met by a drop in the price level. But prices don’t move immediately, implying that the drop in the money supply as a result of the bank run would have had an impact on real output (*).
Now, I completely admit that Moral Hazard is a relevant issue. But is a the cost of letting large financial institutions know that, in a 1 in 100 year collapse in the global economy, they will be prevented from going bankrupt immediately greater than the benefit of avoiding a sharp and self-propogating decline in economic activity? For the bailouts to be a good idea we merely need to say:
- the costs exceeded the benefits,
- this was the best scheme that was able to be approved at the time.
I think both these factors hold – although I completely understand when people feel differently, given that there is a trade-off.