The central banks bailed out the financial system in March 2020, the second time they have done so in 12 years. What is the point of privately owned banks if they require a bailout every decade?

The financial system had gotten itself into such a state in 2008 that the financial authorities concluded that the only way to prevent another Great Depression was to bail out almost every financial institution in the world.

When Covid-19 came around, fearing a financial crisis, the authorities applied all the lessons they had learned from 2008. Nobody received a capital injection or got to sell their dodgy assets to the state. But the central banks did provide liquidity and lowered capital standards, both of which kept the financial system running as if nothing had happened. The financial system would have been much worse of without the central bank support, and that support is not free — bailouts by another name, even if they did pass unseen, lost in all the Covid-19 hoopla.

Are we better off because of the Covid-19 bailouts?

In the conventional narrative, the financial system did nothing wrong in 2020; it was just hit by a rather nasty exogenous demand shock and had to be supported. The turmoil wasn’t its fault, and the central banks rescued us from a financial crisis by correctly applying all the lessons learned from 2008. If central banks had reacted as decisively in 2008, that crisis would also have been averted.


Not quite.

The economy is hit by large shocks all the time, but we don’t bail out most privately owned firms — responding to all the Covid-19 bankruptcies with “good luck with that”. The right answer. Privately owned firms enjoy the benefits of the upside and suffer the downside, the first principle of capitalism.

Not in finance. A big shock comes along, and the system is bailed out, directly in 2008 and with liquidity in 2020.


Why let the financial institutions get all the upside and then enjoy a bailout when things go pear-shaped?

The common view is that the financial authorities had no choice but to support the banks in 2008 and 2020. You see, the financial institutions are essential, and the costs of them failing vastly exceeds the cost of support, not the case for most other private firms. Correct when seen through the narrow lens of static economic analysis — what I once called Excelonomics. If a crisis is unique, a never to be repeated event, the cost of the crisis outweighs the cost of the bailout.

But that is simpleminded and bad economics.

A bailout creates moral hazard. Because we bail the financial system out every time markets are disrupted — the Greenspan put — the financial institutions just take a lot more risk in the comforting knowledge that the central banks will step in to rescue them when the bets go wrong.

Once you start giving away money to a sector, it will find a way to expand its activities so as to increase the size of the cheques.

Meanwhile, all the “Whatever it takes” not only remain in place, but the financial authorities are proud of them.

The price of all the bailouts eventually exceeds the cost of the very few crises we would suffer if the banks were not tempted to take too much risk, as no support is forthcoming.

And there are serious consequences.

Crises empower the financial authorities.

The authorities now ask the right question, “what can we do to prevent a repeat” and come to the wrong answer, “more regulations and more control”. Transferring yet more responsibility for finance to the state.

The new regulations will not prevent future crises, but future crises will make the financial system more and more state controlled.

Then, we have the heavy pressure on the banks to provide credit to all the enterprises squeezed by Covid-19 — what economists call financial repression. The governments want the banks to do more and are looking for ways to force them to do that. Financial regulations help.

The state may find even more power in the newfangled central bank digital currencies.

The bailouts, meanwhile, undermine the credibility of the state. If the financial authorities can do no better than a setup requiring a bailout every decade, neither the authorities nor the governments that empower them appear competent or honest.

And now I get to the existential threat.

What is the point of a privately run financial system if the state has to bail it out every time things go wrong?

Why not just have the state run the financial system?

That would be the worst possible outcome. No matter how we dislike banks needing frequent state support, having the state either dictate how banks are run or even providing banking services is much much worse.

If we end up with a nationalised banking system or one that is lobotomised and run by the state, we can only blame the financial sector for behaving in a way that makes it dependent on state support every decade and the financial authorities that make that support inevitable.

Then you may ask “Jon, fair enough, but what you propose?” I’m certainly no nihilist, but do allow me to leave the answer to more posts, listed below.



Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.