Monday, April 1, 2013

Dean Baker: confusion between saving financial industry and saving financial system

In his post, economist Dean Baker looks at how both the Bush and Obama administrations confused and still confuse saving the financial industry with saving the financial system.

The source of this confusion is the policy of financial failure containment and its corollary, the Geithner Doctrine, that was adopted by the US Treasury and the Federal Reserve.  Under this policy, the Japanese Model for handling a bank solvency led financial crisis and its twin goals of protecting bank book capital levels and banker bonuses at all costs was adopted.

By definition, this policy was designed to protect the status quo including the existing banks and sizable banker bonuses.

In contrast, there is the policy of financial failure prevention on which the global financial system is based.  Under this policy, the Swedish Model for handling a bank solvency led financial crisis is adopted and banks are required to absorb upfront the losses on the excess debt in the financial system.

By definition, this policy is designed to protect the real economy, the taxpayers and the social contract at the cost of greatly reducing banker bonuses.

The Washington Post published excerpts from reporter Neil Irwin's new book,The Alchemists: Three Central Bankers and a World on Fire, under the headline, "three days that saved the world financial system." 
The headline is seriously misleading since it may cause readers to believe the world somehow would have lacked a financial system if the central bankers in Irwin's story had not succeeded in their efforts. 
This is not true. 
Had a financial collapse actually been the outcome, the central banks had the ability to take over failed banks and restart the system. (This is what the FDIC does all the time.)... 
While the immediate hit from the financial collapse would have almost certainly been worse than what Europe and the rest of the world saw in the immediate wake of the initial euro zone crisis, the euro zone and world economy would almost certainly be much better off today if the central bankers had simply allowed the system to collapse. (This assumes that they are as competent as the economic policymakers in Argentina.) 
In this sense, the heroes in Irwin's book can be seen as saving the bankers, who would have been wiped out in a financial collapse, but not really doing much to benefit the rest of society.

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