Russ Roberts: Occupy Wall Street and Washington's History of Financial Bailouts

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RUSS ROBERTS is Professor of Economics and Mercatus Scholar at George Mason University. He is also Research Fellow at the Hoover Institution at Stanford University.

...The protesters are right about one thing: Washington has been coddling Wall Street. But they have missed the most important way that Wall Street lives off the rest of us. Programs like the Troubled Asset Relief Program of 2008 are red herrings. TARP did send $700 billion to Wall Street, but most of it has been paid back.

There is a much more important, albeit quieter, favor Washington has been performing for Wall Street over the last 25 years: When large financial institutions get into trouble, policymakers make sure that their creditors receive 100 cents on the dollar.

The bailouts of large creditors -- such as the 1984 rescue of Continental Illinois, the 1995 rescue of Mexico, and the 1998 government-orchestrated attempt to save the creditors of Long-Term Capital Management -- sent a signal to large lenders that they might lose little or nothing if the investments they
fund go bust. That in turn made lenders much less cautious, allowing financial institutions to use borrowed money, rather than their own capital, to finance
the housing boom.

Using borrowed money instead of equity lets you keep the upside for yourself. Such an arrangement is always appealing. But why did lenders accept such risks when they do not share in the upside, especially when the investments were increasingly risky? Part of the reason is that government created expectations that lenders might get their money anyway.

And they often did. When Bear Stearns went belly up in March 2008, the government did not let the firm go bankrupt. The Federal Reserve guaranteed the toxic assets of Bear Stearns to make the acquisition deal sweeter for J.P. Morgan Chase. But the real impact of the deal was that Bear's creditors -- mostly other large Wall Street firms -- paid no price for financing Bear's debt-financed mistakes. J.P. Morgan Chase honored those obligations 100 cents on the dollar. That reinforced the expectation that large firms could lend and borrow from one another with little or no risk. Reckless leverage is what made the crisis a crisis rather than something milder....

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