The U.S. Treasury has sold a large chunk of its shares of AIG at a price high enough to recover the initial outlay made to bail out the insurance giant, four years ago this week.
News headlines report this as a profit. Does this mean that the bailout was sound policy on the part of the Bush administration and the Federal Reserve?
The quick answer is that no one knows for sure, and no one will ever know. As with other aspects of the ongoing 21st century financial debacle, historians probably will argue about this for years. There never will be a definitive answer. But here are issues to consider.
First, why did we bail out American International Group? It is important to remember that the objective was to save the entire economy not just this particular company.
By September 2008, 13 months after commercial paper markets had seized up and four months after the failure of Bear Stearns, it seemed to many, including Treasury Secretary Henry Paulson, Fed Chair Ben Bernanke and New York Fed President Timothy Geithner, that the economy faced a possible financial meltdown of a magnitude not seen for nearly a century. Events had been snowballing for over a year and, at each juncture, the vulnerability of the financial system turned out to be much greater than supposed.
If things really fell apart, many feared, we faced a situation as grave as that of March 1933, at the low point of the Great Depression, with a 25 percent drop in output and household incomes and an unemployment rate over 20 percent.
Four years ago this week, Lehman Brothers was about to declare bankruptcy, Merrill Lynch and Bank of America were weak, and even Citigroup and Morgan Stanley had problems. Via “credit default swaps,” AIG had guaranteed payment of debt owed to these and other major financial firms. If AIG went bust and could not honor those guarantees, there would be a cascade of defaults and bankruptcies that would bring the financial system to a standstill.
That was the perceived danger. How realistic was it? My personal and highly subjective opinion, is that a meltdown was very likely. I think most economists believe there was some degree of danger, although there is great variation. Some, like monetarist Allan Meltzer who opposed any government intervention at the time, now fault the Fed and Treasury for not having also stepped in to save Lehman. But none of us can prove exactly what that danger was or how severe the outcome actually would have been under different scenarios.
In economic as well as in political affairs, one cannot simply rewind a tape, change circumstances or policies a bit and then hit “forward.” Nor can one construct some sort of computer model of the economy that would be definitive. Financial crises are too complex and occur too infrequently to have any sort of statistical data on which to base a model.
Against a potential decline in annual national income of a couple trillion dollars in a depression that would last for several years, the $1 trillion or so pumped into various failing firms in 2008 would have been money well spent even if not a single dollar was recovered. But that will always remain a matter of debate.
So much for possible benefits to society as a whole. One must also consider potential costs. In general, economists think that government stepping in to save bankrupt firms is a bad idea.
It rewards bad management and creates incentives for resources to be used wastefully. It should only be done when the alternative is clearly worse.
That is what Paulson and others thought about AIG.
However, the fact that we did intervene to save AIG and other financial institutions from bankruptcy has set a precedent that will remain in many people’s minds. The fact that the Treasury ended up recovering its money and that AIG shareholders lost all their investment is irrelevant.
The lesson learned by most is that if very large financial institutions get in trouble, government will do something. Go ahead and take on risk. Heads, we win, and tails, society as a whole loses.
Not everyone has to believe that. Given competitive pressures, however, if large institutions engage in risky behavior, others feel they must do the same, or lose business to the daredevils.
We can say as often as we want that we will never intervene again, that the rules are different, that there will be no more bailouts. But this has no credibility. Past actions speak louder than words.
A final issue is what we have done to prevent future crises. The Dodd-Frank Act is enormously complicated. I, and many other economists, am skeptical about how it will work in the face of a crisis. But the alternative, of simply breaking up large financial institutions, is not acceptable to leading politicians of both parties.
The general population assumes that if we had not bailed out AIG and the banks, the economy would not be any worse off. Most politicians now oppose bailouts. Those who had the courage to vote for the Trouble Asset Relief Program, including Republican House Speaker John Boehner and vice-presidential candidate Paul Ryan, think it political suicide to defend their actions. And while Mitt Romney calls for repealing Dodd-Frank and substituting “common-sense” regulation, neither he nor President Barack Obama are willing to address the continued vulnerability of the global economy to another acute financial crisis.