Questions

The protesters are right about one thing: Washington has been coddling Wall Street. But they have missed the most important way that Wall Street lives off the rest of us. Programs like the Troubled Asset Relief Program of 2008 are red herrings. TARP did send $700 billion to Wall Street, but most of it has been paid back.

 

There is a much more important, albeit quieter, favor Washington has been performing for Wall Street over the last 25 years: When large financial institutions get into trouble, policymakers make sure that their creditors receive 100 cents on the dollar.

 

The economist Milton Friedman liked to point out that capitalism is a profit-and-loss system.   Profits encourage risk-taking. Losses encourage prudence, which is just as important. Over the last 25 years, however, government policy has been laissez-faire when it comes to profits, and socialist when it comes to creditor losses.  That is a very destructive cocktail.  It has encouraged imprudent risk-taking financed with large amounts of borrowed money.   When you subsidize recklessness, you unsurprisingly get a lot more of it.

 

The bailouts of large creditors - such as the 1984 rescue of Continental Illinois, the 1995 rescue of Mexico, and the 1998 government-orchestrated attempt to save the creditors of Long-Term Capital Management - sent a signal to large lenders that they might lose little or nothing if the investments they fund go bust.  That in turn made lenders much less cautious, allowing financial institutions to use borrowed money, rather than their own capital, to finance the housing boom.

 

What Occupy Wall Street Gets Wrong About Inequality

 

Using borrowed money instead of equity lets you keep the upside for yourself. Such an arrangement is always appealing. But why did lenders accept such risks when they do not share in the upside, especially when the investments were increasingly risky? Part of the reason is that government created expectations that lenders might get their money anyway.

 

And they often did. When Bear Stearns went belly up in March 2008, the government did not let the firm go bankrupt. The Federal Reserve guaranteed the toxic assets of Bear Stearns to make the acquisition deal sweeter for J.P. Morgan Chase. But the real impact of the deal was that Bear's creditors - mostly other large Wall Street firms - paid no price for financing Bear's debt-financed mistakes. J.P. Morgan Chase honored those obligations 100 cents on the dollar.  That reinforced the expectation that large firms could lend and borrow from one another with little or no risk. Reckless leverage is what made the crisis a crisis rather than something milder.

 

The received wisdom is that it was the failure to rescue Lehman Brothers that worsened the financial crisis.  But it was the rescue of Bear Sterns' creditors that let Lehman continue to roll the dice, using borrowed money rather than pulling back and raising more capital.

 

The real cost to Main Street has not been the transfer of taxpayer money to Wall Street. The real cost to Main Street has been Wall Street's imprudent lending and investment, which led to lending trillions of dollars to build more and bigger houses.  That was a bad use of precious capital. The incentives to invest wisely have been distorted. And we are all still paying the price for the collapse of highly leveraged firms.

 

This is not capitalism; it is crony capitalism. Occupy Wall Street's diagnosis of a parasitic symbiosis between Wall Street and Washington is correct. The coddling of Wall Street let borrowing get out of control, unnaturally enlarged the banks, and helped justify and fund bonuses that otherwise would have been much smaller.

 

The Fight for 'Real Democracy' at the Heart of Occupy Wall Street

 

But the top one percent includes a lot more people than just Wall Street executives who have been living large because of the opportunity to leverage investments with borrowed money. The top one percent included Steve Jobs, who grew fabulously wealthy by making the rest of us better off.  The same goes for Sergey Brin and Larry Page, the founders of Google.  These innovators make enormous sums of money, but the gains to the rest of us are even larger.  Great innovators make the economic pie bigger.

 

The views expressed in this article are solely those of Russ Roberts.