Paul Krugman: Giveaways to Wall Street erased trust of taxpayers

By Paul Krugman 4:18 PM Monday, November 23, 2009

Recently the inspector-general for the Troubled Asset Relief Program, aka, the bank bailout fund, released his report on the 2008 rescue of the American International Group, the insurer. The gist of the report is that government officials made no serious attempt to extract concessions from bankers, even though these bankers received huge benefits. And more than money was lost. By making what was in effect a multibillion-dollar gift to Wall Street, policymakers undermined their own credibility.

The AIG rescue was part of a pattern: Throughout the financial crisis key officials — most notably Timothy Geithner, president of the New York Fed in 2008 and now Treasury secretary — have shied away from doing anything that might rattle Wall Street. And the bitter paradox is that this play-it-safe approach has ended up undermining prospects for economic recovery.

The job of fixing the broken economy is far from done — yet finishing the job has become nearly impossible now that the public has lost faith in the government’s efforts, viewing them as little more than handouts to those who created this mess.

About the AIG affair: During the bubble years, many financial companies created the illusion of financial soundness by buying credit-default swaps from AIG — basically, insurance policies in which AIG promised to make up the difference if borrowers defaulted on their debts. It was an illusion, because AIG didn’t have the money to make good on its promises.

So why protect bankers from the consequences of their errors? Well, by the time AIG’s hollowness became apparent, the world financial system was on the edge of collapse and officials judged — probably correctly — that letting AIG go bankrupt would push the financial system over that edge. So AIG was effectively nationalized; its promises became taxpayer liabilities.

But was there any way to limit those liabilities? After all, banks would have suffered huge losses if AIG had been allowed to fail. So it seemed only fair for them to bear part of the cost of the bailout, which they could have done by accepting a “haircut” on the amounts AIG owed them. Indeed, the government asked them to do just that. But they said no — and that was the end of the story.

Could things have been different? Some argue that government officials had no way to force the banks to accept a haircut — either they let AIG go bankrupt, which they weren’t ready to do, or they had to honor its contracts as written.

But this seems like a naïve view of how Wall Street works. Major financial firms are a small club, with a shared interest in sustaining the system. It has been common in times of crisis to call on the big players to forgo short-term profits for the industry’s common good.

Back in 1998, it was a consortium of private bankers — not the government — that put up the funds to rescue the hedge fund Long Term Capital Management.

Furthermore, big financial firms have a long-term relationship, both with the government and with each other, and can pay a price if they act selfishly in times of crisis. Bear Stearns, the investment bank, earned itself a lot of ill will by refusing to participate in that 1998 rescue, and it’s widely believed this played a role in the demise of Bear Stearns itself 10 years later.

So officials could have called on bankers to offer a better deal, for their own sake, and simultaneously threatened to name and shame those who balked. It was their choice not to do that, just as it was their choice not to push for more control over bailed-out banks in early 2009.

So here’s the real tragedy of the botched bailout: Government officials forgot that if you want to govern effectively, you have retain the trust of the people. And by treating the financial industry — which got us into this mess in the first place — with kid gloves, they have squandered that trust.

Paul Krugman writes for the New York Times.

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