The "Too Big to Fail" Lie (as applied to US banks)

By: Steve Saville | Mon, Feb 22, 2010
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Below is an excerpt from a commentary originally posted at on 28th January, 2010.

"They are too big to fail" was the reason given for using trillions of dollars in money and guarantees to 'bail out' several large US banks during 2008-2009. Their failure, it was argued, would all but bring the entire economy to a standstill; such were the size and scope of their operations. Providing the banks whatever financial support they needed to remain in business was therefore touted as serving the "public interest". However, the "too big to fail" argument was a giant, multi-faceted lie.

One part of the lie was that rescuing the banks would ensure the continued flow of credit to private individuals and businesses. It is now blatantly obvious that this was not true because bank lending has been in decline ever since the bailouts. Although, perhaps we are being unkind and it should be put down as a basic misunderstanding stemming from the popularity of fallacious Keynesian economic theories.

The crux of the lending issue was/is that the pool of real savings became severely depleted during the inflation-fueled boom of 2003-2007. It should therefore be no surprise that the private economy has since been desperately trying to replenish its savings, and, as a consequence, that there has been less desire and less ability to create new debt. Once the real issue is understood it becomes clear that the banks were never likely to quickly return to their old lending habits and that it would be bad for the economy if they did.

A second part of the lie was that depositors were at risk, when it was actually just the bond- and equity-holders of the banks that were at risk. The bailouts were essentially carried out to prevent the owners of bank bonds from taking losses on their bad investments under a policy that could be aptly named "no bank-bondholder left behind".

A third part of the lie was more a misdirection than a lie, because the ultimate source of the funds for the bailouts was deliberately kept vague. There was always the implication that the government was funding the bailouts, but the government doesn't have or generate any real savings and can therefore never fund anything. The harsh reality is that the bailouts involved a massive transfer of wealth from the rest of the economy to the banks' bondholders in the first instance, and later to the banks' managers and traders.

Understanding how government bailouts of failed businesses are funded reveals the overarching lie that a bank or any other business could ever be "too big to fail". The truth is that one business or economic sector can only ever be given artificial support at the expense of other parts of the economy, so the bigger the business the LESS sense it will make, from an economy-wide perspective, to bail it out. Moreover, when a business fails it doesn't just disappear in a puff of smoke; rather, the parts of the business that are economically viable get sold off and resources get freed-up to be used elsewhere. In the cases of the big banks, the underlying banking businesses were healthy and would have continued to operate under different ownership if the banks had been permitted to go bust.

Unfortunately, the "too big to fail" lie is still going strong. From the government's perspective, the theory that the financial crisis had a lot to do with the sizes of banks* is just too good to let go. This is because it not only provides justification for the huge wealth transfer of 2008-2009 and diverts blame from the government and the Fed; it also creates an opportunity for the regulators to be seen as saviours rather than culprits.

President Obama's current proposal** to limit the size and scope of the banks is the latest in a long line of attempts to portray regulators as saviours, but we wonder if the public is starting to 'wise up'. The proposal came in the immediate aftermath of the Massachusetts election shock and has clearly been designed to redirect the anger of the voting public from big government to big banks, but could the voters finally be twigging to the reality that what's needed, more than anything, is a smaller government? Maybe, although a less optimistic appraisal would be that the average voter still sees no problem with government-enforced wealth distribution as long as he/she is a direct beneficiary of the distribution. In any case, a devout believer in central planning will perceive every problem as a justification to expand the role of government, even when it is patently obvious that government caused the problem. And few are more devout than Mr. Obama.

With regard to the so-called "too big to fail" banks, the correct solution is very simple and requires nothing except the application of basic property rights. The solution is to take away the legal privilege to counterfeit money that the banks currently enjoy, thus putting the banks on a level playing field with everyone else. Not surprisingly, this solution is not up for consideration.

*The immense size that some banks have been able to attain is a symptom, not a cause. It is a symptom of an inherently unstable monetary system -- a system that allows money to be created out of nothing by the private banks and the central bank.

**According to a White House press release last week: "...the proposal would: 1. Limit the Scope -- The president and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit. 2. Limit the Size -- The president also announced a new proposal to limit the consolidation of our financial sector. The presidentís proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits."

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Steve Saville

Author: Steve Saville

Steve Saville
Hong Kong

Steve Saville

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