Rogoff Shreds "When in Doubt, Bail It Out" Policy

Grr. It was so obvious and it never occurred to me…:”When in doubt, bail it out.” I am jealous.

Kenneth Rogoff, who among other things has (with Carmen Reinhart) has created a large dataset on financial crises through history, today takes on the exceedingly permissive posture the US has adopted to the banking industry, simply handing over fistfulls of money with virtually no strings attached, then occasionally making a great show about boxing their ears a bit over private jets. In the meantime, the banks get to run very large risks on the taxpayer nickel and pay themselves handsomely, assured of another rescue if they do screw up. You couldn’t do a better job of writing a prescription for another train wreck.

This piece by Rogoff, is actually refreshingly pointed, and shreds the conventional wisdom that supports the policy of enabling banks that had been engaged in reckless policies. From the Financial Times:

“When in doubt, bail it out,” is the policy mantra 11 months after the September 2008 collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises; it is the job of central banks to prevent bank runs by reacting forcefully in a potential systemic crisis; policymakers should not be obsessed with moral hazard and should forget trying to micromanage the innovative financial sector.

Yves here, OK, I have to stop. Even though this is a straw man, reading that list makes me ill. Back to Rogoff:

This relatively sanguine diagnosis is tempting, but dangerous. There are three basic problems with the view that the costs of greater bank regulation outweigh the benefits, and that the whole problem was the botched Lehman bail-out.

First, the US economy was not exactly cruising along at warp speed in the run-up to September 2008. The National Bureau of Economic Research has the US recession beginning at the end of 2007. Financial markets had begun to exhibit distress from the subprime problem by the summer of 2007. The epic housing bubble had begun to burst six months earlier. Given that the US consumer had been propelling the global economy for a quarter of a century, was it reasonable to think that the inevitable collapse of the US housing market would be a non-event? As Carmen Reinhart and I argue in our forthcoming book This Time is Different: Eight centuries of financial folly, by most quantitative measures, the US economy was heading towards a deep post-war financial crisis for several years before the subprime crisis. Indeed, in related papers, we argued the case long before Lehman hit.

Second, the view that reining in the financial sector jeopardises future growth needs to be nuanced. Certainly enhanced financial development is integral to achieving greater growth and stability. But economists have less empirical evidence than we might care to admit on which financial sector activities are the most helpful. In general, the links between growth and financial development are complex. Mortgage “innovation” in the US was supposed to be helpful by lowering interest rates to homebuyers. Yet, as the crisis revealed, innovation was also a mechanism for levering implicit taxpayer subsidies. More generally, financial innovation was supposed to bring diversification and stability. But in a system-wide breakdown, it also fuelled contagion.

Third, it is dangerous to point to the nascent restoration of profits in the financial sector as clear evidence of a corresponding benefit to the economy. There is an element of arbitrage, as banks borrow at low rates against the implicit guarantee of a government bail-out in the event of a crisis. Do people really believe, as some argue, that moral hazard is a non-issue? Why should large systemically critical financial institutions be allowed to heavily leverage themselves with short-term borrowing? What would be lost if regulators placed stricter capital requirements to discourage arbitrage activities that excessively expose too-big-to-fail banks to systemic risk? Certainly economists have models of why it can be efficient for lenders to keep borrowers on a short leash. Yet these models do not explain why the leash has to be wrapped around borrowers’ necks three dozen times, as in the case of a highly leveraged bank.

The fact is that banks, especially large systemically important ones, are currently able to obtain cash at a near zero interest rate and engage in risky arbitrage activities, knowing that the invisible wallet of the taxpayer stands behind them. In essence, while authorities are saying that they intend to raise capital requirements on banks later, in the short run they are looking the other way while banks gamble under the umbrella of taxpayer guarantees.

If the optimists are wrong, does this mean that the pre-Lehman financial system was one big Sodom and Gomorrah, inevitably condemned to doom? We will never know. Again appealing to my work with Ms Reinhart, theory and history both tell us that any economy that is excessively leveraged with short-term borrowing – be it government, banking, corporate or consumer – is highly vulnerable to crises of confidence. Accidents that are waiting to happen usually do, but when? Neither statistical analysis of history, nor economic theory offer tight limits on the timing of collapses, even to within a year or two.

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivatives book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth-largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the streets to convince Congress. In any event, given the system’s manifest vulnerabilities, and the impending tsunami of the housing price collapse, it is hard to know if deferring the crisis would have made things better or worse, particularly given the obvious paralysis of the political system.

Economists will conduct post-mortems of the crisis for decades. In the meantime, common sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. Better macroprudential action is needed, particularly in reining in sustained, large current account deficits. While such deficits can sometimes be justified, prolonged imbalances fuel leverage and can give the illusion that high growth and asset prices are sustainable. There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

It is good that the economy appears to be stabilising, albeit on the back of a vast array of non-transparent taxpayer subsidies to financial institutions. But this strategy must not be relied on indefinitely because it risks compromising the fiscal credibility of rich-country governments. The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform, and not just starting in five years.

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  1. attempter

    Even this falls considerably short of the truths:

    1. None of this activity of big finance ever added social value;

    2. OTC it only accelerated and intensified the malevolences of wealth concentration, monopoly concentration (M & A), globalization and offshoring, and general deregulation;

    3. In any healthy economy finance is only a small, epiphenomenal sector; where this burgeons, that's always proof that overproduction and the overaccumulation of capital desperate to find an "investment" are bringing on the next crisis;

    4. Speaking generally the destruction of America's real, productive economy; the liquidation of America's middle class and its replacement by a zombie pseudo-middle class puffed up by debt and bubbling asset prices; and the obscene bloating of the FIRE sector, are three malign circumstances which have fed upon and exacerbated one another;

    5. And now with TBTF corporatism and economic autocracy (secrecy and rampant unconstitutional behavior by the exec branch and the unaccountable Fed) the enshrined policy of America, from which ALL other policy flows, we live in what is basically a gutter gangster dictatorship;

    6. All of it, every step of the way, was the abdication of real "innovation", real "capitalism", real value-seeking and -adding, and the entrenchment of feudal rent-seeking, monopoly, calcification, stagnation, a staggering death;

    7. None of it is economically sustainable;

    8. None of it is physically sustainable (Peak Oil and resource depletion);

    So it follows that any policy which at all tries to prop up this zombie system, including even a mitgated, "regulated" existence for the big banks (although they're of course not seeking this), is existentially doomed and morally repugnant.

    Only a policy aimed at the complete destruction of the big finance sector can possibly be successful (by any non-criminal measure of success) and have any moral legitimacy.

  2. Anonymous

    Government and FED supportive to banks and non-actions against arbitrage risks have to been seen in the light of the fact that most Regulators and Financial government people have been working on Wall Cheat and foremost GoldSack.

  3. kievite

    Reform is needed but there is another problem that makes any change problematic. The boom-and-bust economics fueled by credit expansion instituted by Reagan and promoted by all subsequent presidents was ideologically supported by free market fundamentalism brainwashing. "What's the matter with Kansas" documented this brainwashing very well. While at the beginning free market fundamentalism has positive elements of fighting against excessive bureaucratization, it went out of control and became the driving force of dismantling of the all meaningful regulation and neutering all the check-and-balances institutions. It is still going strong, has the party behind it and is still used for the justification of the continuation of excesses in the financial sector (with the smoke screen of words like "innovation"). It also helped to institute the policy of revolving doors which was very effective in converting the government into FIRE sector socks puppet.

    Those two factors mean that it's not easy to downsize FIRE and restore the value of productive sector of economy. Drinking Kool-Aid of market fundamentalism for so long left a lasting brain damage for this nation, the damage the effects of which might last a decade or even a generation. Add to this the problems inherent in the "end of cheap oil" and Japanese "lost decade" looks like a rather optimistic scenario. Lack of political leadership does not help either.

    I am very worried…. I do not think that the US voters understand that the finance sector, rather than servicing the needs of the real economy, was engaged and is still engaged in primarily servicing itself; taxpayers be damned. Also money talk, and they talk especially loudly in politics. As a result the US population outside top 10% bracket needs to pay a huge price for FIRE sector excesses. Possibly facing a lower standard of living for a generation. Banking oligarchy has too strong grip on the Congress and will fight to a bitter end for the self-preservation.

    That makes chance difficult and appearance of the political scène figures like FDR almost impossible until a decade of slide of standard of living creates enough "grape of wrath".

  4. kristiina

    A chilling testimony from Rogoff! Thank you Yves, for posting it. Likewise thanking for Mondays post, Is This the Start of the Big one? that got a flurry of comments, and almost all of it on a side issue.

    It has, by now, become obvious that any reform that would mean curbing the excesses of the financial sector are not going to happen. In Rogoff's words: "given the obvious paralysis of the political system." Woe unto the taxpayer. Powers that be may disregard the moral hazard aspect, but disillusionment and frustration do not bode well for the society.

    There seems to be a tendency in humans to pick up a trifling issue and start a fight over that when facing vast, seemingly unsolvable problems. When the political system and financial sector are fully committed to run a society to ground to preserve their own exalted status, the human response is to argue about the right words to use on discussing presidential performance. This i find sad, terrifying and scary. The scene is all set for a nasty tragedy.

    And yet, Gurdjieff traveled through Russia during the Revolution with a group of spiritual seekers. They were able to earn their living in spite of the upheaval and war, traveling through fronts – unarmed. So, it may be possible to sail through any storm on the real asset we have: ourselves.

  5. Siggy

    Much is being asserted about the apparent failure of the concept of 'free market capitalism'. If the Government, thru any of its agents, acts to bail out an insolvent institution you do not have free market capitalism in operation.

    The liquidation of Bear Stearns and Merrill by forced sale is an effective means of liquidating an insolvent institution. The ordered bankruptcy of Lehman is another. The execution of each of these efforts led to a freeze in the credit markets. The issue of counterparty ability to perform being the brake on activity. In many ways to assert that we have had an enormous failure of of confidence is to miss-direct the focal point of the problem.

    Quite simply we collectively spent more than we earned and we did that over an extended period of time. In order to over spend we over borrowed. The cure is to extinguish that debt that cannot be serviced. You can either pay it down, or by way of bankruptcy you can repudiate it. The faster the process of deleveraging occurs, the sooner it will be possible to begin a recovery.

    Bail outs merely push into the future the ultimate resolution of the problem. Rather like cancer, delayed treatment can be fatal. In our current problem what is being destroyed is our middle class and our ethic of honoring our contracts.

    As a society, we want our freedom and our liberty. To that end we have entered into a contract by and between ouselves, we call it our Constitution.

    If, as several have suggested here, the Constitution is only a piece of paper as are all contracts, that may be abridged at will; then, we are fast on the road to serfdom.

    An enormous part of the current problem is fraud. The sale of difference contracts that the seller had no ability to honor, and wherein the sales were willing and deceitful is a fraud. Yet there has been precious little done in the way of referrals to and prosecutions by the Justice Department.

    Rather than baili outs there should be prosecutions!

  6. DownSouth

    kievite said…"Reform is needed but there is another problem that makes any change problematic. The boom-and-bust economics fueled by credit expansion instituted by Reagan and promoted by all subsequent presidents was ideologically supported by free market fundamentalism brainwashing."

    This is an excellent point and one that was explained in a BBC video Yves posted here some months back:

    If you haven't viewed this video, make sure and do so because it is absolutely outstanding.

    A counter-argument to the theories of Freud, as well as to Bernays and the Frankfurt School who applied them, is made by Hannah Arendt. She acknowledges the power of propaganda and brainwashing, but argues that reality always has a way of reasserting itself. In a functioning democracy, this happens quicker than in a totalitarian regime, but it always happens.

    In Crises of the Republic Arendt says it is the "problem-solvers" who place almost unlimited faith in the power of public lying. The problem-solvers are men "drawn into government from the universities and the various think tanks" to solve all the "problems." (As an aside, let me point out that Arendt is picking up on a theme articulated a generation earlier by Reinhold Niebuhr. Niebuhr dubbed the problem-solvers "wise men" or "scientist-kings.")

    But, as Arendt goes on to explain, the problem-solvers are only deluding themselves:

    The only limitation to what the public-relations man does comes when he discovers that the same people who perhaps can be "manipulated" to buy a certain kind of soap cannot be manipulated–though, of course, they can be forced by terror–to "buy" opinions and political views. Therefore the psychological premise of human manipulability has become one of the chief wares that are sold on the market of common and learned opinion. But such doctrines do not change the way people form opinions or prevent them from acting according to their own lights. The only method short of terror to have real influence on their conduct is still the old carrot-and-stick approach. It is not surprising that the recent generation of intellectuals, who grew up in the insane atmosphere of rampant advertising and were taught that half of politics is "image-making" and the other half the art of making people believe in the imagery, should almost automatically fall back on the older adages of carrot and stick whenever the situation becomes too serious for "theory." To them, the greatest disappointment in the Vietnam adventure should have been the discovery that there are people with whom carrot-and-stick methods do not work either…

    It may be natural for elected officeholders–who owe so much, or believe they owe so much, to their campaign managers–to think that manipulation is the ruler of the people's minds and hence the true ruler of the world.

    What is surprising is the eagerness of those scores of "intellectuals" who offered their enthusiastic help in this imaginary enterprise, perhaps because they were fascinated by the sheer size of the mental exercises it seemed to demand…

    No reality and no common sense could penetrate the minds of the problem-solvers.

    I therefore disagree with your statement: "I do not think that the US voters understand that the finance sector, rather than servicing the needs of the real economy, was engaged and is still engaged in primarily servicing itself; taxpayers be damned."

    I think the voters fully understand what is going on. The only ones who don't understand it are the "problem-solvers" (Geithner, Summers, Bernanke, etc.) and, of course, the politicians.

    The economic realities are in the process of reasserting themselves. It's just that it's going to take a couple of elction cycles (or maybe even a revolution?) for the political realities to catch up.

  7. DownSouth

    In this same vein, and since there has been so much discussion on this blog over the past few weeks concerning the president's role in the economic crisis, Arendt surprisingly exculpates presidents from playing a significant role in public lying:

    Oddly enough, the only person likely to be an ideal victim of complete manipulation is the President of the United States. Because of the immensity of his job, he must surround himself with advisers…who "exercise their power chiefly by filtering the information that reaches the President and by interpreting the outside world for him." The President, one is tempted to argue, allegedly the most powerful man of the most powerful country, is the only person in this country whose range of choices can be predetermined… This, of course, can happen only if the executive branch has cut itself off from contact with the legislative powers of Congress; it is the logical outcome in our system of government when the Senate is being deprived of, or is reluctant to exercise, its powers to participate and advise…

  8. ScottB

    "Certainly enhanced financial development is integral to achieving greater growth and stability. But economists have less empirical evidence than we might care to admit on which financial sector activities are the most helpful."

    As to the first sentence–I'm still waiting for someone to show me a recent financial innovation that was helpful to society.

  9. Dave Raithel

    I take it that Yves Smith's characterization of "straw man" refers to "Too many …"? Because there is nothing said in the remainder of that paragraph I haven't run across somewhere in the finance/political blogosphere – probably usually linked to through my Seeking Alpha email-drop. So the "straw man" characterization goes to Rogoff's asserting "too many …" (as if there is some number that would be enough …?)

    Down South: Admire your (and Hannah's) sanguineness. Wish I shared it. I don't think that the Frankfurters would say reality doesn't always reassert itself – just that when it does, it's much worse for the wear. Case in point: I can agree with somebody (maybe Joe the Plummer, e.g.) that Fed/Treasury policies re the banks are screwing the American taxpayers. Between him and me, who is more likely to add something like "And it's part of the Internationalist Blue Hat Commie Zionist Roosevelt & Arms of Krupp One World Government Conspiracy"? (And maybe he wouldn't say that – but odds are pretty good he's running in a circle where such things are believed and said …)

    It's an empirical question whether there are enough people whose social and political values cannot be manipulated like preferences for soap, nor enticed by carrots or cudgeled by sticks. Watching the Dems and Obama flail about when confronting "straw men" arguments ("The Dems want single-payer socialism") and outright lies (Obama will kill your grandmother – oh, remember he's not even an American – it would be gauche to say he's "black", ya know) drains me of the hope you seem to have.

  10. Voice of Indignation

    The Arendt quotation is absurd. Arguably "reality" asserted itself in Germany in 1945, in the USSR in 1955, and in China in 1975 (note that in the latter two cases the regime continued to exist). How many people met untimely deaths before that happened?

    The propeganda will work for a longer time than you can stay solvent.

  11. Kelli K

    I am sorry Kristiina doesn't like the tangents these threads always move onto (usually very quickly). I find them very entertaining, like a fast moving dinner party conversation, rather than a moderated seminar in which the professor keeps bringing everyone back to the main point.

    At any rate, back to Rogoff, it's pretty clear that root and branch reform is off the table for now, as we have not even finished laddling out the taxpayer moneys that were allocated at the height of the panic. This truly is a slow motion trainwreck, such that angry mobs will descend upon the scene before fire engines arrive to put out the flames. THAT, to my mind is the heart of the problem.

  12. Carlosjii

    The US and the western nations are beginning a painful re-adjustment to a lower standard of living.

    “The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression [recession], is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market interest by means of credit expansion. There is no means of avoiding the final collapse of the boom expansion brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of voluntary abandonment of further expansion, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises, as quoted in Methods of a Wall Street Master, Victor Sperandeo. Von Mises is the main proponent of the Austrian School of Economics.

  13. DownSouth

    @Dave Raithel,

    There is no doubt that Arendt was a modernist, and that her optimism regarding the Enlightenment and science was never totally extinguisged. (Niebuhr, by the way, like yourself, did not share this optimism in science or the Enlightenment. Niebuhr did, however, have an abiding faith in religion.) Arendt maintained her optimism despite the fact that her lifetime spanned what was probably one of the greatest known failures of science and the Enlightenment, and the fact that that failure most likely touched her life in a very personal way:

    The Nazi's cornerstone precept of "racial hygiene" gave birth to their policy of "racial cleansing" that led to the murders of millions. It was developed by German phsysicians and scientists in the 19th century and is rooted in the period's Social Darwinism…

    Although notions of race have a long history, it was ironically the Scientific Revolution followed by the Enlightenment and then the Age of Reason, emphasizing science and rationality, that were the wellsprings for biologically based racism.
    —Francois Haas, "German science and black racism–roots of Nazi Holocaust", FASEB Journal

    Arendt preserved her belief in scientific objectivism (and in modernism) by separating what she believed to be bonafied science from that which was practiced by the "problem-solvers," something she called "pseudo-science:"

    Needless to say, this is not science but pseudo-science, "the desperate attempt of the social and behavioral sciences," in the words of Noam Chomsky, "to imitate the surface features of sciences that really ahve significant intellectual content."


    In spite of their undoubted intelligence–it is manifest in many memos from their pens–they also believed that politics is but a variety of public relations, and they were taken in by all the bizarre psychological premises underlying this belief.

    Still, they obviously were different from the ordinary image-makers. Their distinction lies in that they were problem-solvers as well. Hence they were not just intelligent, but prided themselves on being "rational," and they were indeed to a rather frightening degree above "sentimentality" and in love with "theory," the world of sheer mental effort. They were eager to find formulas, preferably expressed in a pseudo-mathematical language, that would unify the most disparate phenomena with which reality presented them: that is they were eager to discover laws by which to explain and predict political and historical facts as though they were as necessary, and thus as reliable, as the physicists once believed natural phenomena to be.

    However, unlike the natural scientist, who deals with matters that, whatever their origin, are not man-made or man-enacted, and that therefore can be observed, understood, and eventually changed only through the most meticulous loyalty to factual, given reality, the historian, as well as the politician, deals with human affairs that owe their existence to man's capacity for action, and that means to man's relative freedom from things as they are.
    –Hannah Arendt, Crises of the Republic

  14. DownSouth


    I suppose each person has to decide where they fit on the optimism-pessimism continuum, and certainly the more optimistic person always runs the risk of being branded a hopeless romantic or a believer in the supernatural. But it is just not in the constitution of some people, such as Arendt, Niebuhr, and perhaps myself, to adopt the highly pessimistic outlook of, let's say, a Jonathan Swift or a Leo Tolstoy:

    If one adds together Swift's pessimism, his reverence for the past, his incuriosity and his horror of the human body, one arrives at the attitude common among religious reactionaries–that is, people who defend an unjust order of Society by claiming that this world cannot be sustantially improved and only the "next world" matters. However, Swift shows no sign of having any religious beliefs…


    [T]he most essential thing in Swift is his inability to believe that life–ordinary life on the solid earth, and not some rationalised, deodorised version of it–could be made worth living. Of course, no honest person claims that happiness is now a normal condition among adult human beings; but perhaps it could be made normal, and it is upon this question that all serious political controversy turns. Swift has much in common–more, I believe, than has been noticed–with Tolstoy, another disbeliever in the possibility of happiness. In both men you have the same anarchistic outlook covering an authoritarian cast of mind; in both a similar hostility to Science, the same impatience with opponents, the same inabilty to see the importance of any question not interesting to themselves; and in both cases a sort of horror of the actual process of life…
    –George Orwell, "Politics vs. Literature"

  15. skippy


    I hear and feel where your coming from although I wonder more too which exists in the common persons mind ie. Those that do not debate with in them selves, other than how to achieve goals inherited environmentally (see town hall meetings again). Hell as exemplified repetitively here and across the econ blog sphere, people are taxpayers and not citizens, where and when did that line get so blurred crossed. On that note is the Constitution a living or dead document, some thing that must be run around in circles for conveniences sake *immediacy* or is it an idea which binds/bonds us together regardless of our deferences.

    I summit too you, our recent environment was a direct result of generational grooming by a small percentage of the hole that is the republic, and is not an expression of free citizens in any way, shape or form or informed by the citizens as a hole. In fact through my studies and experiences. I worry that the Constitution was conceived as a placebo to dull the mind, not as a conspiracy of likened minds working in concert, but as a result of a business deal under which our founding fathers (all business men/Lady's *Yves included* not allowed/mens club)could conduct their enterprise of self enrichment (see family feud with European social betters). With only the Husbandry of their chattel as a sticking point IE. bound slave or free roaming.

    Is not the antitheses of law by which this republic is governed the preservation of property from the mob supported by landed army's/law enforcment to which they may preserve their status by virtuous mannerism's (bloody romans).

    How much knowledge (science) is usurped only to signal which direction the herd must move and too benefit the few, with their preservation of status as the only consideration (see Sucks-Man Gold/WTF Harvard or as you reference Nazis). IMO class warfare is a top down affair not the other way around.

    In ending, Lie's from the top down are the problem, self preservation of status and undue reward are the beast. Science is the observation/discovery of that what existed far before we existed and will remain if we perish, we are merely observers to that what was wrought and may never know how or why such acts were commited. We can only effect our own reality's, but not that of the Universe and it does not suffer fools.

    Skippy…respect your position, learned self, effort to achieve enlightenment in mans dealings, although the universe does have the final say.

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