In late May, the Congressional Budget Office released its most recent assessment of the cost of the Troubled Asset Relief Program (TARP). This occasioned far less thoughtful discussion of the role of government than it should have, which is unfortunate because there are few better examples of good and bad government interference in markets than those the program embodied.
The original Troubled Asset Relief Program was signed into law three weeks after the September 2008 stock market meltdown and rolled a lot of financial activities into one piece of legislation. The law allowed the U.S. Treasury to buy some $700 billion of collateralized debt obligations (aka toxic assets). These assets were made up of billions of dollars of mortgages, which were, on average, remarkably safe. The problem with them was that it required months to determine the few that were not. As a consequence, they could not sell.
This meant the otherwise healthy banks that held them could not pay off depositors who wanted their money back. While most of these institutions were commercial or investment banks, a run on their assets would’ve likely sparked a general run on banks across the country. So, for all intents and purposes, the program allowed the U.S. Treasury to act a lot like George Bailey using his honeymoon money to quell a bank run. Just like George and Mary Bailey, the U.S. Treasury got all its money back from supporting liquidity in healthy banks.
If the program had ended there, it’d have cost the government nothing and been heralded an unambiguous success. But it did not end there.
The Troubled Asset Relief Program was also used take over financial firms that were basically bankrupt. These include AIG and Fannie Mae and Freddie Mac. It also was extended to bail out two other bankrupt businesses: GM and Chrysler. Here the government lost money.
Popular discussion about the government’s interference in markets often conflates the process of insuring liquidity in healthy banks and bailing out failed businesses. It is important to understand the difference. All governments work to ensure a liquid banking system, and, like it or not, it is part of a modern banking system. It is a fairly light touch of government. Bailing out failing companies is a bad practice; this recession demonstrates why with perfect resonance.
First, bailing out a failing company incentivizes risky behavior. Freddie Mac failed in part because it was leveraged 70:1 on assets. The government takeover prevented the type of widespread legal action that would have offered a clear lesson across the economy.
Second, bailing out failing companies effectively punishes those who were doing the right thing. Ford Motor Co. spent the past two decades making cars and trucks that people wanted to buy and streamlining their production costs. Neither GM nor Chrysler could be so inconvenienced. Eschewing high quality production at a reasonable cost, they instead hired lobbyists. Our government rewarded this.
The lesson for big business is to take heavy risks and hire lots of lobbyists. Those are the real costs of government bailouts.
Michael J. Hicks is the director of the Center for Business and Economic Research and an associate professor of economics in the Miller College of Business at Ball State University.