Published on Tuesday, June 9, 2009 by The Age (Australia)

Break the Banks, for the Good of the People

Bailing out the big US banks has done nothing to improve them

by Joseph E. Stiglitz

With all the talk of "green shoots" of economic recovery, America's banks are resisting efforts to regulate them. While politicians talk about their commitment to regulatory reform to prevent a recurrence of the crisis, this is one area where the devil really is in the details - and the banks will muster what muscle they have left to ensure that they have ample room to continue as they have in the past.

The old system worked well for the banks so why should they embrace change? Indeed, the efforts to rescue them devoted such little thought to the kind of post-crisis financial system we want, that we will end up with a banking system that is less competitive, with the large banks that were "too big to fail" even larger.

It has long been recognised that the US banks that are too big to fail are also too big to be managed. That is one reason the performance of several has been so dismal. When they fail, the Government engineers a financial restructuring and provides deposit insurance, gaining a stake in their future. Officials know that if they wait too long, zombie or near-zombie banks - which have little or no net worth, but are treated as if they were viable institutions - are likely to "gamble on resurrection". If they take big bets and win, they walk away with the proceeds, if they fail, the Government picks up the tab.

This is not just theory; it is a lesson learned, at great expense, during the savings and loan crisis of the 1980s. In a financial restructuring, shareholders typically get wiped out, and bondholders become the new shareholders. Sometimes, the government must provide additional funds, or a new investor must be willing to take over the failed bank.

The Obama Administration has, however, introduced a new concept: "too big to be financially restructured". The Administration argues that all hell would break loose if we tried to play by the usual rules. Markets would panic. So, not only can't we touch the bondholders, we can't even touch the shareholders - even if most of the shares' existing value merely reflects a bet on a government bail-out.

This judgement is wrong. The Obama Administration has succumbed to political pressure and scare-mongering by the big banks and, as a result, has confused bailing out the bankers and their shareholders with bailing out the banks.

The Obama strategy's current and future costs are very high - and so far, it has not achieved its limited objective of restarting lending. The taxpayer has had to pony up billions, and has provided billions more in guarantees - bills that are likely to come due in the future.

Rewriting the rules of the market economy - in a way that has benefited those that have caused so much pain to the entire global economy - is worse than financially costly. Most Americans view it as grossly unjust, especially after they saw the banks divert the billions intended to enable them to revive lending, to payments of outsized bonuses and dividends.

This ersatz capitalism, where losses are socialised and profits privatised, is doomed to failure. Incentives are distorted. There is no market discipline. The too-big-to-be-restructured banks know that they can gamble with impunity - and, with the Federal Reserve making funds available at near-zero interest rates, there is ample money to do so.

Some have called this "socialism with American characteristics". But socialism is concerned about ordinary individuals. By contrast, the US has provided little help for the millions of its people who are losing their homes. Workers who lose their jobs receive only 39 weeks of limited unemployment benefits, and are then left on their own. And, when they lose their jobs, most also lose their health insurance.

America has expanded its corporate safety net in unprecedented ways, from commercial banks to investment banks, then to insurance, and now to cars, with no end in sight. In truth, this is not socialism, but an extension of long-standing corporate welfarism. The rich and powerful turn to the Government to help them whenever they can, while needy individuals get little social protection.

We need to break up the too-big-to-fail banks; there is no evidence that these behemoths deliver societal benefits that are commensurate with the costs they have imposed.

This raises another problem with America's too-big-to-fail, too-big-to-be-restructured banks: they are too politically powerful. Their lobbying efforts worked well, first to deregulate, and then to have taxpayers pay for the clean-up. Their hope is that it will work again to keep them free to do as they please, regardless of the risks for taxpayers and the economy. We cannot afford to let that happen.

© 2009 The Age

Joseph E. Stiglitz is University Professor at Columbia University. Among many books, he is the author of Globalization and Its Discontents. He received the Nobel Prize in Economics in 2001 for research on the economics of information. Most recently, he is the co-author, with Linda Bilmes, of The Three Trillion Dollar War: The True Costs of the Iraq Conflict.