The Bailout Economy

Nicole Gelinas, a certified financial analyst and a fellow at the Manhattan Institute, writes frequently about financial policy for such outlets as The Wall Street Journal, the New York Post, and City Journal. She is the author of a new book, After the Fall: Saving Capitalism From Wall Street—and Washington (Encounter), which makes the case that policy makers responding to the current economic crisis have forgotten the lessons of the Great Depression. The bailouts of the last two years, she argues, have undermined the market discipline that allows capitalism to function.

Associate Editor Peter Suderman spoke with Gelinas in January. 

Q: You talk a lot about the need for banks to fail, but to do so in an orderly way. Can you explain the difference between orderly failure and chaotic failure?

A: If you look at the bank failures of the 1920s or '30s, we had market discipline of the banking industry. But these were disorderly failures that ended up sucking so much money out of the economy that they helped precipitate panic and lack of confidence in the economy. This was market discipline that extracted too great a price. The elegance of the Federal Deposit Insurance Corporation was that you still had market discipline, so that if a bank made bad decisions or just had bad luck, it would go out of business. But you had some order because you protected small depositors. You don't want homemakers and plumbers to have to pore over their bank's balance sheet.

So people get a safe place to put their money but of course are free to take risks elsewhere if they want to. This worked well until the 1980s, when we decided some banks were too big to fail. And then we started having a system that wasn't predictable or consistent, but arbitrary.

We learned these lessons back in the 1930s. We just forgot them. The absence of adequate regulation is not freer markets. It's nationalization—and such public disillusionment with capitalism that it harms capitalism.

Q: What do you mean when you say "free market"?

A: What we have now is not a free market. The bailouts that we've seen create a system in which some companies know that if they amass enough risk, they can take the economy hostage, and their lenders will be bailed out if there's a crisis. So one of the important things it means is that any private-sector company should operate under the credible threat of failure.

The crisis was not a crisis of free markets. It was a crisis of improper government intervention in free markets. We've been bailing out too-big-to-fail banks since 1984, and the result was a financial system so distorted by government interference that it eventually collapsed under the weight of these distortions.

Q: You've written that "we can't prevent failure—and we shouldn't." It strikes me that part of the problem is psychological: Lots of people don't want to accept that there aren't always easy solutions. Do you see a way to create a public understanding that the government can't always step in and "fix" the economy?

A: Sometimes I wonder how much of this is the public and how much of this is politicians of both parties pushing their own agendas—which mean bigger government and more power for them. One thing I think is heartening is that the public has been pretty consistently against these bailouts. People in New York and Washington seem to think that populism against the AIG bonuses shows that people are against wealth. But that's not really true. People are against the government subsidy of failed executives.

Q: So maybe the question is how to ensure better regulators.

A: The best regulations are consistent, predictable rules that are known in advance. We don't need smarter regulators. We need smart people operating in markets that can't be gamed.