In the past six months, financial-industry stocks have gained almost 30 percent, nearly double the return of broader indices. Two weeks ago, Goldman Sachs reported a record $3.4 billion quarterly profit. The investment bank's employees are on track to earn 30 percent more than they did at the height of the credit bubble three years ago, and its surviving rivals are racing to keep up.
So did TARP and the government's other extraordinary efforts to revive the financial industry "work"? Is the financial crisis now a bad dream, with an economic recovery sure to follow? (Other NRO contributors comment here.)
TARP "worked" in the sense that the world's investors trusted the U.S. government's willingness and ability to take over the obligations of a failed financial system. Indeed, previous efforts to save the economy by insulating financial-industry failures from the free market's verdict have "worked" since 1984, when the Reagan administration stepped in to rescue the lenders to a faltering Continental Illinois, then the eighth-largest bank in the nation.
The government had no choice but to step in and save the economy from the financial industry's disaster this time around, just as it had no choice with Continental, and just as it had no choice when it engineered the rescue of the lenders to the Long-Term Capital Management hedge fund more than a decade later.
In each case, the government's blunt power successfully suppressed market signals — although each time, Washington's task has gotten harder.
In each case, too, Washington did have a choice about what to do after the immediate crisis had passed: U.S. policymakers could have renewed the regulatory infrastructure through which big financial firms could fail and lenders to those firms could take their warranted losses in a consistent, predictable manner, thus reintroducing badly needed market discipline. This job is not that difficult. Lawmakers and regulators did it effectively between 1933 and 1984. First, it takes political credibility. Second, it requires the consistent application of regulations that are proven to strengthen markets so that they can withstand failure, including limits on borrowing and individual company exposure to complex financial instruments.
Instead, Washington has preferred to let each extraordinary episode recede into memory, allowing a financial industry undisciplined by markets to encourage the nation to borrow well beyond its means. Indeed, for the past 25 years, Washington has consistently subsidized reckless risk-taking in finance. When the government subsidizes anything, it gets more of it. The financial crisis that started in 2007 was not a surprise, but was the natural result of such subsidies.
Unfortunately, the Obama administration has been all over the map regarding its plans for how to end the "too big to fail" problem — and Republicans haven't been a rational counterweight. As a result, firms such as Goldman Sachs can earn double-digit returns for their shareholders — and just as generous returns for their employees — because lenders to such firms know that the government stands behind them.
Without a robust mechanism through which big or complex financial firms can fail, much of the financial industry will remain insulated from the healthy discipline of market forces. The next financial crisis, then, will be inevitable — and will sorely test Washington's ability to protect the economy from it.
Bottom line: free markets (i.e. conservatism) works every time it's tried. Similarly, Nanny State Big Government fails every time it's tried. As Gelinas points out, each successive Nanny State intervention means that the root problem is covered up again, leading to an even bigger catastrophe 'next time'. So, if we're now experiencing what we are experiencing -- and remember, we haven't seen the worst of it yet -- can you imagine what 'next time' will be like next time?
Is the entire American economy 'too big to fail'? If so, who bails it out?
There's my two cents.