The Government’s Response in the Case of a Financial Crisis Requiring a Bank Bailout

A prior post explained how financial crises develop and the need for a government bailout of banks to prevent a complete collapse of the economy.

There are two ways governments could respond to a financial crisis. One way is to take over failing banks and restructure them. This involves creating new healthy entities that can continue to operate with only loans that can be serviced, and putting loans that can’t be serviced into new entities that will enter bankruptcy where investors and lienholders will suffer the losses. The other is to give the banks money to continue to weather the storm over a long period of time by investing the money in other areas and using the income to deleverage and write off bad loans as they occur.

Political reasons have dictated the second course in the case of the current financial crisis. The financial sector has tremendous political power through contributions to politicians and influence with the national press. Both political parties are subject to this lobbying pressure and succumbed to it.

The bailout funds from the government and through the Fed’s buying of troubled assets has been used by banks primarily to speculate in foreign currencies and invest in productive assets denominated in foreign currencies that pay higher interest rates. Funds that are not invested in this way are simply left in reserve accounts at the Fed where they earn interest.

The government has done little or nothing to reduce overall debt in the private sector by forcing banks to accept losses on bad loans. Again, for political reasons, it has not embarked on any significant government programs to create demand in the economy. Instead it has chosen to allow the financial sector to use government bailouts to generate the kinds of income described above to slowly, over decades of high unemployment, to allow the deleveraging process to slowly bring the economy back to health.

To compound the problem, government  has done little or nothing to curb the excesses that caused the problem over the last several decades, in terms of reregulation of  banks and investigating and prosecuting fraud that occurred in the financial sector. The financial sector continues in much the same mode it did before the crisis, threatening the reinflation of the asset bubbles that caused the current crisis.

So what can be done about this dilemma? Stay tuned to this blog.