"The big message of the financial crisis is that you want to become too big to fail"

George Mason economics professor Garett Jones on TARP, moral hazard, and the true costs of bailing out the financial sector.

In 2008, in the midst of massive economic turmoil, Congress passed the Troubled Asset Relief Program, or TARP, in hopes of sparing the economy from what many viewed as a near certain collapse. Since then, TARP, which funneled hundreds of billions of dollars into the coffers of the nation's biggest banks, has become a symbol of both Washington's overspending and its corporatist leanings. But while popular sentiment has hardened against the law, elite consensus has come to embrace it as a resounding success. Last fall, Politico's Ben Smith called it "a success none dare mention" and Washington "insiders' finest moment, a successful attempt to at least partially fix their own mistakes." Earlier this week, Washington Post columnist Robert Samuelson, a frequent critic of government intervention in the economy, echoed the sentiment that TARP was a success, writing that the real lesson of the program is that "only the government is powerful enough to prevent a complete collapse." Many of the law's supporters pointed to a recent report by the Congressional Budget Office stating that despite the initial $700 billion price tag, the cost to taxpayers would only amount to about $19 billion.

I've been tempted by these arguments myself. It's not that I ever thought TARP was a great idea or an experiment worth repeating. Clearly there were serious problems with the Treasury Department's claims about the program's effects. But ultimately, TARP seemed like a lesser problem—a relatively small expense that may even have had some short-term positive effects.

Garett Jones, a professor of economics at George Mason University, has spent the last two years arguing otherwise. I spoke with him earlier this week about the why he blames TARP for much of America's economic struggles, and why its long-term consequences could be more serious than most people realize. What follows is an edited version of our conversation.

Reason: The elite consensus seems to be that TARP was actually a pretty successful program. Even market-oriented economists like Bob Samuelson have defended it. I know you disagree. Why are they wrong? Why was it a bad idea?

Garett Jones: There are a few reasons. Normal economics tells me that when the government takes over an industry, it's bad. Normal economics tells me that government takeovers lead to bad performance. And we actually have a lot of evidence on this. Government-owned banks are associated with much worse economic outcomes around the world. That doesn't mean the banks failed. Auto industries in the Soviet Union never went into bankruptcy. But that also doesn't mean that they were good.

What's going on here instead is that the market looked at TARP and said, "Wow, our financial system is going to be a lot worse—a lot less productive—than we thought." That's a major reason, I think, why the stock market collapsed after TARP was enacted. The market had looked at bad economic news about mortgage markets, about financial markets, for a good solid year beforehand. And it took the passage of TARP for it to completely tank.

I'm willing to be pretty bold about this. There really wasn't much new economic news about the state of the banks that came out when the stock market had its eight days of terror. What was coming out was the government's ever-growing willingness to completely take over and micromanage the "too big to fail" banks.

Reason: So you would say that at least the primary cause of the crash was TARP and the government showing itself to be willing to be intervene?

Jones: I think there's a solid shot that it's most of it. It's at least a substantial part of it. I know that I'm in the minority here. It's just me and John Taylor right now who are willing to say this openly.

But yes. The news that still doesn't get enough attention is that the collapse happened after TARP was passed, not before. People have this story they tell each other where the economy was collapsing so we passed TARP. It's closer to the truth to say the opposite.

Reason: When people talk about TARP, when they justify it, they say it was necessary because the alternative was to face a crisis—or at least a very high risk of a crisis.

Jones: Exactly, yes.

Reason: Do you think we were in a crisis situation when TARP passed? And was there any other alternative. That seems to be a big part of the case: First, we were in a crisis. Second, there was no alternative.

Jones: I completely disagree. I said so at the time. I wrote my first words on it just a few weeks after TARP was enacted, and then I spun it out into a full length paper called "Speed Bankruptcy." The basic story is the same story the Irish people are debating now. It's the idea that you make bond holders share the pain. It's called burden-sharing now. It took years to come up with a term to capture what you need to do when your banks are in the tank. And the answer is: You tell long-term bond-holders, "Sorry, you're not going to get paid. You're not going to get paid 100 cents on the dollar. You're going to have to take a haircut."

Reason: So your argument is that the lost money's got to come from somewhere. And bondholders are the people who took the risk and therefore should face the negative consequences.

Jones: Precisely. And if you do the smart thing, you don't just give them haircuts, but you do an equity conversion. You bring in a whole mass of shareholders, many of whom will actually be pretty informed about the business. So if you turned a fraction of the bonds into shares, then you create a whole new class of shareholders who can come in, take over the firm, put in new management, and bring in fresh blood. All the good things the government was trying to do during the months when they owned the banks.

Reason: Let me just challenge you a little bit more on this. Part of the narrative surrounding TARP was that when the initial vote didn't go through, there was panic in the market. Isn't there an argument to be made that TARP did in fact assuage some of the market's fears? We had multiple votes. The first vote failed. And in response, the market reacted negatively.

Jones: When the House rejected TARP, the stock market fell 7 percent. When Congress eventually passed TARP, the stock market fell 40 percent. I know which of those two numbers I prefer. I don't claim that the 7 percent was totally caused by the rejection of TARP. I don't claim that all of the 40 percent was caused by the passage of TARP. But you know, seven versus 40—I'll pick the smaller number of the two.

Reason: Let's talk about costs. The CBO says TARP is only going to cost taxpayers about $25 billion [Update: CBO now estimates it will cost $19 billion]. According to some people, certain investments in the banking sector actually made taxpayers a profit. Maybe you still think that's money we shouldn't have spent. But given that we were looking at something closer to $700 billion initially, isn't TARP a relatively small problem?

Jones: No, I think you have to look at the real cost. If I'm even one third right, if a third of the collapse of GDP was caused by the government takeover of banks and how the market looked at that, then the big collapse in revenues we've seen in federal, state, and local governments—a third of that is the cost of TARP. So the real cost of TARP is not the cost of buying the shares of the banks. The real cost of TARP is the fact that—just like in most countries where banks get taken over by the government—the economy grows worse, and the government brings in less money. That's the real cost of TARP.

Reason: The argument you're making here is about moral hazard. TARP set up a system in which, long term, banks are going to behave worse in the long term, and are not going to make smart cost-benefit decisions. It's already cost the economy to some extent. And it will eventually cost both taxpayers and the economy much more in the long run.

Jones: Yes. A lot of people think of moral hazard as excessive risk taking—as gambling with the government's money. Heads I win, tails you lose. But I think what we should really think about is that this leads to mushy, semi-socialism. That's the real risk. When banks know that the government will come and bail them out, it's not that they're going to take the big gambles. That's part of it, but the other part is that it leads to malaise—organizational sluggishness.

So an equally important risk is that banks just get sluggish. They don't worry about maximizing profit. They just turn into government agencies. They won't do that completely because they're not completely owned by the government. But if they're 5 percent owned by the government, then they're 5 percent mush.

Reason: They understand that they have a safety net below them and therefore will not be as careful.

Jones: Yes. The real risk is the risk of mushy, semi-socialism—institutional lethargy.

Reason: One of the other points critics have made is that it's actually encouraged the consolidation of big banks. Do you think that's true? Do you think that will increase the chance of further long-term financial sector problems?

Jones: The big message of the financial crisis is that you want to become too big to fail. That's a clear message of the financial crisis. To be a successful bank in America, you want to become too big to fail.