Here’s Why the Bank Bailouts are Still Crippling the Economy

 

The bank bailouts of 2008 continue to bring the broad economy harm, all the while restraining the ability of the banking system to get back on its feet. This shouldn’t surprise anyone.

To put it simply, while business failure of any kind is always painful for investors and employees alike, it’s a happy sign of economic revival for revealing in living color that capitalism is working. Business failure hardly constitutes business disappearance, and the beauty of failure is that it ensures that poorly managed assets are released at frequently low prices to managers with a stated objective to develop those human, mechanical and financial inputs more effectively on the way to growth.

To make basic what already is, failure signals an economy on the mend simply because the bad business ideas, investments and labor misuses are cleansed from the economy. Failure means that bad ideas won’t be perpetuated, that an ineffective status quo won’t be maintained, and that’s why Silicon Valley’s rather ruthless approach to failed concepts means that it thrives, while Michigan languishes for propping up concepts that rational investors and workers long ago left behind as yesterday’s news.

Looking at banking itself, bailouts and the presumption of same hardly enhance the industry’s health; instead too many marginal producers are allowed to stay in the game and destroy capital thanks to a government willing to cushion their every mistake (think Citigroup (C)). In a banking system characterized by the freedom to fail, we’d have long ago rid ourselves of Citi (NYSE:C) and myriad other financial institutions, and their bankruptcies would have coincided with enhanced market share for the successful in our midst such as Frost Bank (having avoided risky banking practices, the San Antonio-based bank refursed TARP funds), not to mention that the successful would be overseeing the very capital that the ineffective continue to deploy unwisely.

As for the naïve suggestion that some banks have grown too large such that they must be broken up into smaller, less “systemically important” (a sad bit of phraseology on its best day) entities, the genius of “freedom to fail” is that if applied to banks, the downsizing that the dim desire would arguably be the norm. Indeed, absent the presumption that the government would/will ride to rescue of dead banks and their counterparties, the counterparties would necessarily diversify their bank dealings (as do small investors with stocks through mutual funds) so as to limit their exposure to any one institution.

Markets work if only we let them, and much as Lehman Brothers’ collapse was only a major event insofar as many market actors had grown to expect the bailout of any “systemically important” (another worthless, mythical concept) institution, if the mere notion of “government bailout” were cleansed from Washington’s unfortunate bag of policy tools, no bank would grow large enough such that its implosion would have any major market impact. The banking system struggles, its struggles scare the daylights out of investors, but both wouldn’t be factors if the political class would simply get out of the way.

All of which brings us to one of the latest sad, and entirely too predictable Wall Street Journal headlines: “U.S. Pushes Mortgage Deal”. And then in the article’s first paragraph it was written that “The Obama administration is trying to push through a settlement over mortgage-servicing breakdowns that could force America’s largest banks (NYSE:BAC) (NYSE:C) (NYSE:JPM) (NYSE:WFC) to pay for reductions in loan principal worth billions of dollars.”

The seemingly simple minded among us might first ask how the “U.S.”, meaning our federal government, could have any dealings in mortgages given a Constitution that in no way empowers any such involvement. The above would be true, but then us simpletons suffer under a two-party political system in which one expresses worship of our founding document all the while ignoring it, while the other doesn’t even pretend that its actions are even remotely informed by the Constitution at all. Pick your poison, or better yet, don’t vote as a way of not encouraging the political class altogether.

Back to our sad reality, thanks to the politically correct and economically cruel belief within both major parties that home ownership is a “good” that must be promoted by Leviathan, our allegedly limited federal government is very much entangled in the housing and lending sectors, and we taxpayers inevitably suffer those distortions wrought by our government nannies. All of which returns us to the banks and the unfortunate bailouts of 2008.

With major lenders already subsidized by federal housing programs created to foster greater ease among banks to make non-economic loans, once those institutions failed at least partly due to the imposition of the aforementioned programs, Washington couldn’t then let the banks die. Not only might this lead to a reduction in the way of home loans, but thanks to government support of the banking industry such that they grew large enough to be systemically material, the government had to protect what its policies created.

The long-term result is that far from saving the banks (NYSE:XLF), the federal government merely delayed their descent into irrelevancy; the U.S. economy the long-term victim under such a scenario.

To understand why, it has to be remembered that once a business of any kind takes government aid, it’s no longer in the business of profit. Instead, it serves a new, non-shareholder constituent in the form of political masters who don’t care about profits. Politicians see businesses as social institutions meant to promote all manner of activities that sound compassionate, but that only bring distress to businesses, investors, employees and customers.

In this case, as thanks for the bailouts, banks will be forced to give their irresponsible borrowers a somewhat free pass on loans dishonestly secured, while the savers and investors whose parsimony lies at the core of all economic growth will be shunted aside. All economic activity is funded by savers, and the economy will suffer another body blow due to the Obama administration’s despicable act that tells savers to drop dead.

As for the banks, no doubt the bailouts kept them on life support, but owing to continued federal meddling in their ability to be profitable (think the Volcker Rule, capital reserve requirements, and the aforementioned mortgage modifications to name but three), their decline has merely been delayed. Basically the federal government saved them with an eye on slowly strangling them.

Logic says they should have seen this coming, and refused all bailout money, but so deluded were they as to their alleged importance, they forgot that important sectors are rendered meaningless by government aid. A lesson learned? One can hope.

John Tamny is a senior economic advisor to Toreador Research & Trading, a senior economist with H.C. Wainwright Economics, and editor of RealClearMarkets and Forbes.

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