You might think that the purpose of bailing out banks is to protect the deposits, the money that people keep in the banks. But that’s not it at all. The stated purpose of the Wall Street bailout is to increase lending — to “unfreeze the credit markets” so that banks will make more loans. It hasn’t worked — banks are being even tighter with their lending requirements than they were when the Wall Street bailout was first approved — but the Obama administration is continuing it on the theory that it may eventually work.
There may be other reasons to funnel money into the banks, but it is certainly not for the purpose of keeping the deposits safe. If that were the priority, the banks teetering on the edge would be shut down, and the money paid out to the depositors. The longer these banks are left running, the greater the risk that there will be no money left for the depositors beyond the limited payouts provided by deposit insurance. Deposit insurance is the only bailout depositors can reasonably expect. The banks, meanwhile, are being kept running on the theory that it is good for the economy.
Economists and financial experts are by no means in agreement that keeping virtually all the banks going is good for the economy. No bank can be saved unless it can eventually make a profit, and one of the reasons it is so hard for banks to make a profit is that the banking system has so much excess capacity. Shutting down a third of the banks, if indeed that many were to fail, would make it easier for the banks that remained to be profitable. That potential for profit, again, is necessary for the banks to ultimately survive. Looking at it this way, the more banks we prop up, the more banks we will see fail.
The same logic applies if what we want is more lending. A bank that is failing can hardly make new loans with confidence, but if depositors take all their money out of that bank and put it in a healthy bank, the healthy bank will be able to make loans. If lending is what is needed to make the economy recover, and I am not sure that it is as important as some are saying, the sooner we shut down the failing banks, the sooner the economy will recover.
In the end, I think the real reason Washington is propping up the banking system is that the people there want more time to figure out what to do. Yet they have already had years to study the problem and prepare a response — this financial crisis did not exactly sneak up on us, but had already become evident, in its broad outlines at least, three years ago. The delay has been costly — costly in a way that has made “trillion” a household word. By now, policymakers in Washington should be encouraged to protect what is actually necessary for a functioning economy while allowing anything else that cannot justify its existence on its own merits to shut down.