Smoke and Mirrors

There are a large and growing number of people that are absolutely fed up with the government continuing to bail out banks (and auto companies, but that's beyond my circle of competence). To back up just a little, there were a large amount of people who were not in favor of the bailout from the beginning. It is for this huge segment of the population that I am compelled to write a somewhat apologetic justification for the massive amount of government intervention in the financial system.

There is something very well known, but not fully appreciated about the basic concept of banking. Here's what happens: you put your money in a bank, and that evil banker goes out and invests your money, pretending it's his own, to make a profit. In exchange for your money the banker either pays you some interest rate or at least supposedly gives you safe and continuous access to your funds, so that you don't have to have a personal safe and your own monetary system. The key to all of this is the belief that your money is actually safe and accessible. But banking is all one big hoax; David Copperfield has nothing on your average banker. Your money isn't actually there. It's invested somewhere else, which the banker may or may not be able to get quickly in the event that you actually do want all of your money at once.

For the most part, this is rarely a problem. You fully believe that your money is not only there today, but will also be there tomorrow and 30 years from now. The banker keeps plenty of cash on hand to supply what he thinks will be enough to make customers happy and to ensure that your Starbucks purchase isn't declined. The issue comes when you no longer believe that your money is safe.

This confidence problem caused economic disasters throughout the history of the world. The Great Depression is the most glaring example in modern history, but there were "panics" (in America) starting in 1785 and happening every 15-20 years or so up until 1929. These are what I refer to as true "panics." People started to look up under Copperfield's stage and realize that maybe he didn't actually make the elephant levitate - and it scared them to death. They pulled money out of banks in droves and on most occasions, caused the entire economy to completely fail.

In the 1930's, though, the government decided that something absolutely had to be done in order to stop panics, and consequently Depressions, from happening. For this reason, they not only set up a strong regulatory frame work to oversee banks, but they more importantly set up the Federal Deposit Insurance Corporation. In doing so, they decided that to make people feel more safe, they would essentially guarantee most citizens' deposits in banks. If your bank goes out of business, no big deal! Uncle Sam will write you a check for your funds. The importance of this "invention" is enormous. For 70+ years, there were no true financial panics, and many thought there never would be one again. This allowed the economy to grow at an unbelievable rate over time without being interrupted and thrown back 30 years because of a stampede of irrational human fear. Loans and capital flooded into the economy thanks in large part to the simple belief money in banks was and would continue to be backed by the full faith and credit of the U.S. government, which hadn't been questioned since the early 1800's.

That brief walk through history brings me to the modern crisis. To put it mildly, the Great Depression would have had nothing on what would have happened had the American government and subsequently nearly every other major world government not stepped in to stem the effects of the atomic bomb that was the U.S. Housing Market Collapse. The FDIC is the key to the argument, and because politicians and regulators are scared to death to tell you the real reason for the bailout, I'll go ahead and show you Copperfield's trick.

The U.S. Government would have bankrupted if there had not been a bailout. This would have caused every other major economic world player to also collapse, since everyone holds owns some of our debt. Great Britain would have yearned for the days of the Battle of Britain in lieu of 30-50% unemployment. China would have reverted back to a 3rd world country. The U.S. would no longer be a superpower. There would be an enormous world-wide power grab and populist movement, not unlike the situation that led to the rise of Hitler. We would be in a nuclear winter without ever having dropped a real bomb.

The reason that the government would have bankrupted is simple. Citigroup would have played a large role in this and is just one of many institutions that would have led to this enormous problem. The company, at one time, had nearly 3 trillion dollars in assets. That's a loose term for where bankers "invest" the money that people give them. A substantial portion of the money people trusted to Citigroup were FDIC guaranteed. The FDIC only had about 50 billion dollars in funds at the time, and Citigroup was well on its way to becoming insolvent. There is simply no way that the FDIC could have covered the cost of its guarantee. To be sure, they have an open line of credit with the Treasury, but once Citibank goes... then the real panic sets in. That's when Regions, Fifth/Third, Bank of America, and any number of other major players also start to see deposits leaving in droves. At that point the loss to the FDIC becomes so large that the government has to issue trillions more in debt just to fund the FDIC's lifeline. We're running at a huge deficit already, but can you imagine what it would be like if the FDIC essentially had to write a check for every insured dollar in the country? While some banks would surely have survived, as has been the case in past panics, the government simply would not have been able to sell enough debt at cheap enough levels to sustain the FDIC guarantee. Without that, there is no banking system. There are no loans. There are no debit card or check purchases. The economy is thrown back to the 1800's for 20-30 years provided that the government somehow manages to keep the country together and maintain power.

Because that situation was not only plausible but highly likely, Uncle Sam had to do some extraordinary things to ensure that he didn't have to make good on the FDIC promise to the entire country. The 750 billion dollars in hard bailout money is just a drop in the bucket of what the total economic cost of a collapse would have been. The government had to maintain the illusion that your guarantee is still good without having to actually prove it in a large way. I'm generally very against anything resembling a government hand out, but this exception simply had to be made. Sometimes in war, you have to make very hard decisions, and that's what this is- a war. You got drafted back in September 2008 without ever being properly notified. We have all made a huge sacrifice today so that our children and grandchildren can (hopefully) enjoy peace and a standard of living in excess of our own. It's true that we've also burdened them with even more debt, but to summarize Warren Buffett, sometimes it's better to have to pay for a lunch later than to have no lunch at all.