December 12, 2011
The Secret $586 Billion Bailout
Bloomberg News reported on the $586 Billion “bailout” program executed by the Federal Reserve, with terms that make it impossible to track who got the money.
Ah, the problems with a secret half-trillion dollar public program are many. Increased chance of fraud. Too little public accountability. Lack of public knowledge about which institutions needed it (most of us would care if our personal savings were in a bank being propped up by the Fed). But consider this basic Free Market reason:
Consider a system with two banks: One, SafeBankCo, offers products to the market at a slightly higher price, required by ultra-safe banking practices. RiskyBankCo does the opposite, and offers lower prices through much of the economic cycle. When times get tough, RiskyBank goes to SafeBank to transfer risk, and must pay the higher price to do so. The system not only can accept the two levels of risk, but over the long run there should be an equilibrium by which RiskyBankCo has more market share (i.e. lower prices attract more customers) but transfers profits to SafeBankCo during tough times. In fact, there is nothing inherently wrong with either business model. SafeBank foregoes profits during the boom years, then makes it up in recession years. RiskyBank knows it will have to pay excessively high prices for protection during a recession, but with proper management has reserves built up during boom years to do so.
Nothing is wrong, that is, until the Fed sets up a secret $586 billion program. Now RiskyBankCo has no need to go to SafeBankCo, and instead gets propped up at continued “cheap money” rates. SafeBankCo, realizing that their business model is obsolete has no choice but to take risks at the same pace, in the same practice, as RiskyBankCo. The existence of the secret bailout programs creates a race to risk for both banks. In our example it is just two banks, but the same holds true for an example of two hundred banks.
Public “bailout” at least has the reputational cost associated with taking bailout money. Secret bailouts do not. By removing a business reason for any bank to adopt the SafeBankCo business model, the entire system is made more risky. Who bears the risk? The people, the currency, and the system itself ultimately must pay the price for the risk, though almost always by pushing the price into the future.
It bears repeating: There is something grossly immoral about a system that externalizes costs onto the future to pay for the systemic fiscal addictions of today.
