The core logic behind my critique of macroeconomic stabilisation is that stability (and stabilisation) breeds systemic fragility. But this does not imply an opposition to all macroeconomic intervention, especially in a scenario when past stabilisation has left the macroeconomy in a fragile state. It simply insists on restricting our interventions to actions that preserve the essential adaptive character and creative destruction of our economic system.

A resilient framework of macroeconomic interventions must satisfy the following conditions:

  • a focus on mitigating the most damaging consequences of disturbances on the macroeconomy rather than stamping out the disturbance at its source.
  • a focus on discretionary interventions targeted at individuals rather than corporate limited-liability entities and limited to times of systemic crises.
  • emphasis on maintaining general economic capacities and competences rather than protecting the specific incumbent entities that provide an economic function at any given point of time.

In theory monetary and fiscal policy interventions can easily fulfil all these criteria. In practise however, the history of both interventions is characterised by a systematic violation of all of them. The long history of propping up insolvent financial institutions via the TBTF guarantee and central bank ‘liquidity facilities’ combined with the doling out of fiscal favours to incumbent corporates has left us with a fragile and unequal economic system. As Michael Lewis puts it, we have “socialism for the capitalists and capitalism for everybody else” and the system shows no signs of changing despite the abysmal results so far. To paraphrase Robert Reich, behind every potential “resolution” of a debt crisis lies yet another bailout for the banks.

The pro-bailout proponents argue that there is no other option. According to them, allowing the banks to fail will bring about a certain economic collapse. In this post, I will argue against this notion that bank bailouts are inevitable and unavoidable. I will also lay out a coherent and simple alternative policy program to get us out of the mess that we’re currently in without having to undergo a systemic collapse to do so.

My policy proposal has three legs all of which need to be implemented simultaneously:

  • Allow Failure: Allow insolvent banks and financialised corporations to fail.
  • The Helicopter Drop: Institute a system of direct transfers to individuals (a helicopter drop) to mitigate the deflationary fallout from bank failure.
  • Entry of New Banks: Allow fast-track approvals of new banks to restore banking capacity in the economy.

The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. The helicopter drop of direct transfers helps prevent a deflationary collapse and the entry of new banks helps maintain lending capacity thus negating both concerns.

The Helicopter Drop

In order to promote system resilience and minimise moral hazard, any system of direct transfers must be directed only at individuals and it must be a discretionary policy tool utilised only to mitigate against the risk of systemic crises. The discretionary element is crucial as tail risk protection directed at individuals has minimal moral hazard implications if it is uncertain even to the slightest degree. Transfers must not be directed to corporate entities - even uncertain tail-risk protection provided to corporates will eventually be gamed. The critical difference between individuals and corporates in this regard is the ability of stockholders and creditors to spread their bets across corporate entities and ensure that failure of any one bet has only a limited impact on the individual investors’ finances. In an individual’s case, the risk of failure is by definition concentrated and the uncertain nature of the transfer will ensure that moral hazard implications are minimal. This conception of transfers as a macro-intervention tool is very different from ideas that assume constant, regular transfers or a steady safety net such as an income guarantee, job guarantee or a social credit.

Entry of New Banks

I have discussed in a previous post why entry of new banks allows us to preserve bank lending capacity without bailing out the incumbent banks. A similar idea has been laid out by David Merkel as a more resilient way to undertake TARP-like interventions. The fundamental principle is quite simple - system resilience refers to the ability to retain the same function while adapting to a disturbance. It does not imply that the function must be provided by the same incumbent entities. In fact, we are already beginning to see an expansion in non-bank credit as the era of low borrowing costs due to the implicit guarantee to bank creditors comes to an end. New banks unencumbered by the need to make up their past losses will be much better positioned to meet the credit demand from the real economy.The process of new firm entry in banking can be encouraged in many ways:

  • Fast-track approvals
  • Reduced capital requirements
  • TARP-like seed capital participation as David Merkel has laid out.



Many commentators have criticised the ‘Occupy Wall Street’ movement for not having an agenda and a list of demands. But as Michael Lewis points out, their protests are not without merit. The slogan ‘We are the 99 percent’ captures the essence of the problem which is the explosion of the share of the national income captured by the richest 1% of the population. If this inequality was perceived to be fair or if it had occurred at a time of prosperity for the masses, it is unlikely that there would have been any protest at all. But as I have pointed out, the rise in income captured by the richest 1% is primarily driven by the rents captured by and through the financial sector. The same doctrine of macroeconomic stabilisation that acted as the source of these rents has also transformed the economy into a financialised and cronyist system unable to sustain a broad-based and sustainable recovery. Simply allowing the failure of insolvent banks and financialised corporations and putting an end to the flow of rents towards the banks will go a long way towards reducing the level of inequality in the economy. At the same time, the entry of new firms will restore the economy’s competitive and innovative dynamism.



1. What about situations with financial contagion tipping banks over into insolvency without any solid 'fundamental' reasons? 2. Why would I want to open a bank in the midst of a financial crisis where banks are falling left right and centre? However fast it might be approved. How would I quickly reach a level of intermediation efficiency that took some other institutions years or decades to reach? 3. For or against deposit insurance?


1. Try to prevent bank failure due to liquidity problems and we get more illiquid banks. The moral hazard is clear - Raghu Rajan and Doug Diamond wrote a paper on this. A more failure-prone banking system will look a lot different than our current one. Many of the reasons for failure such as banks' maturity transformation are no longer beneficial enough to economic growth to be worth protecting 2. Again, in Europe non-bank lending is already picking up simply because the funding advantage of TBTF is shrinking. Even if the govt needs to participate in equity infusion, I'd rather they seed new banks than save old ones. 3. I'm neutral to deposit insurance for "small" amounts which used to be the case till the 60s. and ban blatant arbitrage schemes like CDARS. At the very least, the levels of insurance need to come down dramatically in the US.


Isn't the elephant in the room here the deposit insurance? In your scenario in which insolvent depository institutions are forced to fully recognise their losses and wound up, FDIC obligations must be met. Aren't the transfers required for deposit insurance going to dwarf the proposed individual crisis transfers? if so then presumably reducing FDIC cover is a step that needs to be done first. Question is by how much? If yes to that, then would you exclude corporates (who after all are holding the largest balances) from insurance? If so, how?


I think wiping out a large portion of unsecured creditors, pref. shareholders etc should suffice in most cases. Atleast in the TBTF universe I don't think it's insured deposits that are the crux of the problem. The current crisis was not funded by insured deposits a la the S&L crisis of the 80s. But as I mentioned in the previous comment, the level of insurance definitely needs to be brought down afterwards. And yes, corporate balances definitely must not be insured to the extent that they exceed the insurance limits - which they obviously do in most cases.


"I think wiping out a large portion of unsecured creditors, pref. shareholders etc should suffice in most cases." I often hear this argument made, but are there any actual quantitative studies on this? The other problem is that MMFs would be burnt to a crisp.


Try this paper And yes - MMFs would be burnt to a crisp. But think of it this way - the more the collapse in shadow money, the more the deflationary impact and the larger the transfer can be without going past the inflation target. Obviously many people will be a lot worse off. But I am certain the impact on the income distribution will be strongly progressive.

Nicolai Hähnle

I'm curious for a clarification: When you talk about reducing capital requirements, what exactly are you talking about? Lowering Basel-style requirements? Or do you want to limit the absolute lower bound on capital that is required to form a new bank?


Nicolai - I mean Basel-style requirements. IMO, if we allow failure of banks, then capital requirements are not so important. Lower capital and more regular individual bank failure can even make the system as a whole more resilient by preventing connectivity from building up to excessive levels (similar to how regular fires build resilience in a forest). But this is not a critical point to the discussion above.


Two problems with the above ashwin: 1) You're picking losers, which is even worse than picking winners. 2) In a micro-chaos setting, uninsured shadow banking should have most of the market. Micro chaos dominated by regulated banking entities runs counter to your own thesis.


Where am I picking losers? Just enforcing some market discipline. And yes, in my preferred new regime we may have uninsured shadow banking dominate the market. This isn't an ideological stance - simply that in my experience, banking regulation is at best useless and at worst harmful. But I realise that most people disagree with me on this. What I do believe is essential is that failure should be a regular occurrence in any regime if it needs to be resilient.

Counterparties | Felix Salmon

[...] Three simple policy steps to restore “macroeconomic resilience” — Macro Resilience [...]


You are picking losers because you are assuming that insured deposits are more deserving than others. Given that we both decry the principle of deposit insurance it would be consistent to avoid doing that. A better plan is to start lowering the thresholds incrementally and then later let what's left of the risk free superstructure collapse - after all, its already collapsing if you measure the collapse by returns to risk free fixed income. I also think you might be being a bit hasty and underestimating how long the elasticity of the ZLB can prop things up. Lastly if you genuinely believe in the shadow sector as the long term future then crucifying it in favour of the currently regulated ponzi fixed income/insured sector risks tainting it forever in the eyes of the man on the street. If that happens, an autocracy is almost inevitable.


Also I meant to say, there is no such thing as market discipline if you hold that the market is a crony-capitalist abomination. If that is what you think (and I agree) then respecting its rules is the opposite of respecting market discipline.


My main perspective here is to try and lay out a simple plan which IMO will get a recovery going and put the economy on the right path quickly. Yes - we can reduce insurance gradually but that'll take time. And I really don't think its a big factor here as I mentioned earlier. I want to pay deposits off in this "quick" plan because its the legal thing to do - no ideology involved here. About how long it can hold up, if you start unwinding all the myriad support systems from the CBs holding the banks up right now it will collapse like a house of cards IMO. I don't know what the future is and I don't really care - happy to let the market figure that out. And once failure is allowed, I think the system will become a lot less crony capitalist.


"I don’t know what the future is and I don’t really care – happy to let the market figure that out." I think that is a flawed position. You cannot declare that the market is structurally unsound and at the same time appeal to it to sort things out. The market is a social construction that is ultimately underwritten by trust in its institutions. Its not a platonic reality. To address this I think you'd at least need to outline how you imagine the market structure might transpire post-collapse and how it might stabilise matters in the aftermath. Its not credible to proscribe a planned and deliberate (if only by the sin of omission) collapse and then leave the aftermath to to the invisible hand which is after all the greatest myth of out time, as I have outlined here:


Let me rephrase it - you're asking me to predict the future. I have some thoughts on the subject obviously but nothing more. I think you'd see a system with very little maturity transformation for example. My main point regarding banking is that we need a system where failure is a possibility and a reality. It's the absence of this "invisible foot" that IMO is the problem with the industry and has infected much of the real economy as well.


I fully agree that the future has to dispense with faux guarantees. But, I *am* asking you to predict the future because that's the ticket to play if you want to turn the oil tanker 180 degrees. In fact its not an oil tanker, its a passenger liner and one needs to pay attention to the views of the passengers. A solution proposal is only possible in reality with a vision of the future that people can buy into or at least discuss. As for maturity transformation I agree with that too - as long as deep financial markets continue to operate. IN fact I think we are already there mostly - most all funding is short term from the lender's POV and nobody holds a 25 year government bond to term.

Devin Finbarr

Generally I like the proposal a lot. "The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. " In your proposal, are you eliminating the FDIC? With deposit insurance in place, there is zero reason for the government to step in and bail out banks. Main street loses nothing, but the bank equity holders lose everything, as they should. Even better would be to add double liability to equity holders plus hold executive bonuses and stock dividends in escrow for seven years. Now that I read your comments ... I seem to be more of a fan of deposit insurance than you are. I would actually make deposit insurance unlimited so as to give corporate investors a safe alternative to money market funds. And if I was restructuring things right now, I would fold all current money market funds into normal FDIC backed accounts, and warn corporations against their use. As long as equity holders a) have substantial capital at stake b) are in a first loss position and c) have an incentive structure that makes the equity holders think long term (such as holding profits and bonuses in escrow), then deposit insurance will not create a moral hazard problem. The equity holders control management of the bank, and the equity holders will have a very strong incentive to make good loans, because it will be their skin on the line. If you're interested, I have my own pet proposal on financial reform - see How to reform the banking system and Assorted thoughts on the economy.


Scepticus - I get what you're saying and you have a point. Thanks for the comments - I'll give the matter the thought it deserves. A part of me suspects that the system of the future will look radically different and I'm reluctant to speculate without giving it a lot more thought than I have so far.


I agree that there is no need to have deposit insurance. An electronic wallet in which people can hold their money is enough for cash needs and term deposits without maturity transformation for longer term investment needs, which are not guaranteed. The helicopter drop - Personally, I'm sympathetic to georgism and want a citizens dividend, but an occasional helicopter drop is better than nothing. I believe that the land tax also acts as a stabilizer since the tax automatically rises in regions and times that are doing well and reduces for regions and times that are doing badly. Entry of new banks - no different from any enterprise. Always welcome.


Devin - Thanks. As discussed in the comments, I don't think deposit insurance is at the heart of the current crisis (unlike say the S&L crisis in the 80s). Enforcing losses on unsecured creditors should more than suffice in most cases. Banks have been bailed out and unsecured creditors made whole despite the presence of deposit insurance for many reasons. But the ones put forth most often are the ones I'm trying to tackle - deflationary collapse and collapse in lending capacity. Your banking proposals are essentially a set of regulations. My main problem with this approach is one I have gleaned from experience - that banks can and will game pretty much any regulation you can throw at them. I have a set of posts on similar topics under the category . I wish we could regulate away the problem but the entire long arc of post-WW2 financial market evolution is one of banks gradually building up the tools that enable them to circumvent any regulation that you can throw at them. Minsky is also excellent on this topic. Just to take your point on equityholders and escrow-like mechanisms enforcing discipline as an example, the "innovation" of synthetic derivatives allows banks to construct as negatively-skewed a bet as they want. So they can construct a bet which appears to be profitable for 29 out of 30 years and then blows up catastrophically in the 30th losing a few hundred years worth of profit. For an outsider or regulator, it is impossible to regulate this behaviour. You need creditors to be vigilant and essentially have skin in the game so that they're not willing to lend at cheap rates and allow banks to lever themselves up.


Prakash - Thanks. My problem with constant certain transfers is simply their incentive effects which won't be good. On entry, my core point is that protecting the incumbents is essentially a way to construct a barrier to entry. You need to allow possible destruction of the incumbent to create the conditions that will incentivise a new entrant.

interfluidity » The lump of unfairness fallacy

[...] violence to widely shared norms of fairness. See, for example, Ashwin Parameswaran’s “simple policy program“. On a less grand-scale, you’ll find that very few fairness concerns arise if [...]


Ashwin, in case you didn't see it, Hussman recently provided a few numbers on the portion of banks' balance sheets that would be available to cover the cost of failure. For both BAC and Citigroup, he calculates the figure as 31%. As he puts it: "this is well beyond what is sufficient to buffer any loss that the company might take on its assets, while still leaving customers and counterparties completely whole. To say that Bank of America can't be allowed to "fail" is really simply to say that Bank of America's bondholders can be allowed to experience a loss." I'm with him (and you) on this issue, have been for many years. That this wasn't done back in 08/09 was a tragedy. Still, as you suggest, there will almost certainly be a second chance, and probably before all that long. Unfortunately, I can't say I'm particularly optimistic either.


Ingolf - Thanks. I hadn't seen that and I agree with Hussman's math but wouldn't go so far as to say that it'll be more than enough for one reason - the off balance-sheet exposures and the derivatives safe harbour provision will eat up a lot of that buffer. But still, depositors will almost certainly not take a hit.


The question is , who would buy BoA assets in the event of a failure, and what would they pay for them? Let us assume that the other TBTF banks are also busy failing at the same time. Until the assets were successfully sold off the depositors couldn't get anything, after the FDIC funds had run out. Note that I'm not arguing that these institutions should be allowed to fail, I just don't believe its going to be as easy as some here are suggesting.


I'm not saying its going to be easy but its absolutely doable. The presence of the transfers program will stabilise the economy and allow new buyers to have confidence that a collapse will not be tolerated. And the assets don't exactly have to be sold instantaneously - FDIC can follow usual process for taking over and disposing of banks.


"And the assets don’t exactly have to be sold instantaneously – FDIC can follow usual process for taking over and disposing of banks." FDIC was designed for dealing with individual failures, not a general bankruptcy of the whole sector. However assuming you are correct and depositors are kept whole after the banks they had been using are all wound up, where do they then place their deposits? This relates to my question about who would buy the assets I guess, since only new institutions having a substantial base of financial assets would be able to accommodate the deposits.


Do the assets necessarily have to be sold? Couldn't the bank's unsecured liabilities instead be converted to equity? I'm no lawyer, but such an approach wouldn't seem to violate property rights. After all, it's not unusual in a bankruptcy for creditors to end up owning a company. It might actually be "fairer" to creditors; they'd be left in control and have a fighting chance of eventually recovering some of their losses. It would also leave well capitalised institutions in its wake, perhaps sufficiently so to begin to realistically deal with their more dubious assets.


So the normal way would be for the deposits and assets to be sold as a package. And Ingolf yes unsecured creditors could be converted to equity if that suffices to cover losses.


We're not talking about converting unsecured creditors to equity here, we are talking about: 1) wiping out all unsecured creditors and equity holders completely. 2) hoping that the banks assets can be *sold* to cover depositors and other secured creditors. Then assuming that is all OK, that there remains somewhere to deposit the deposits. I don't see what relevance the fate of unsecured creditors has to my questions above?


Ashwin may have a different take, but I was suggesting "failed" banks be put through a form of chapter 11. Existing equity holders would almost certainly be wiped out, but unsecured creditors would not. Instead, they'd likely be left with full ownership. The need for the painful and uncertain steps you lay out would therefore be avoided.


Ingolf, thanks, now I see where you were going. Isn't it the case that outside of the US, failed banks do (in theory at least) use the standard bankruptcy process anyway?

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[...] doing violence to widely shared norms of fairness. See, for example, Ashwin Parameswaran’s “simple policy program“. On a less grand-scale, you’ll find that very few fairness concerns arise if underwater [...]

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[...] they become insolvent is a pre-requisite for achieving macroeconomic resilience. In my previous post I outlined how allowing such failure can be managed without causing a deflationary economic [...]


Scepticus, I don't know I'm afraid. Perhaps someone who does can chip in.

Devin Finbarr

"Your banking proposals are essentially a set of regulations. My main problem with this approach is one I have gleaned from experience – that banks can and will game pretty much any regulation you can throw at them. " The main thrust of my proposal is to rely less on written regulation and more on incentives and personal discretion. No insurance company should ever insure a risk it does not understand. The FDIC executives should expel any bank that was creating synthetic assets or doing anything more than well tested, vanilla banking. "This is too complex for me to understand and/or regulate" or "this just smells fishy" is a perfectly valid reason for the FDIC to expel a bank. They are the insurance company, they decide who they wish to insure. The FDIC executives and shareholders have a very good incentive to balance risk and reward. If they are too tight, there would be no lending, and thus no fees from the FDIC insurance premiums. If they are too loose, the banks blow up, and the executives and equity holders are extremely severely punished. The political leaders only have to set exactly how severely punished in order to regulate the level of risk taking. One could be as conservative as saying that if the FDIC goes bankrupt the executives should go to debtors prison, or as relaxed as only clawing back the last five years of bonuses.


Devin - the problem with discretionary regulation is the issue of regulatory capture. At the very least, you need to stop the revolving door between government and finance first.

Michael Strong

What is the anticipated magnitude of the Helicopter Drop? How, exactly, is it determined? I read the link, but the details are far from well developed. And how do we know what magnitudes and pacing of helicopter drops are adequate? I don't expect a full blown, detailed analysis, but your suggestion is worthy enough that it would be worth explore magnitudes a bit to see just how realistic this is.


Michael - The size of the helicopter drop depends upon the deflationary impact of allowing the incumbent banks to fail. If we did nothing, then simply allowing a collapse would probably lead to atleast a similar level of deflation as the banking collapse in the early 30s i.e. ~25%. But the commitment of the helicopter drop itself should allow us to restructure the banks without such a collapse. New entrants and fresh capital may move in quicker on the basis that money supply will not be allowed to collapse. The aim should be to start small and build up if necessary. If the transfers result in an overshooting of the inflation target, then the excess can be mopped up with a simple consumption tax. Given the ease with which the program can be ramped up, my preferred approach would be to tinker cautiously and re-evaluate constantly. The need for such a program is primarily driven by the fragility of our current economy which has been brought on by past errors. In a resilient economy, the amount of such transfers needed should be minimal. Also, when intervention is needed I'd rather intervene with an equitable, neutral policy rather than doling out fiscal favours or bailing out banks.

Ray Phenicie

"Transfers must not be directed to corporate entities – even uncertain tail-risk protection provided to corporates will eventually be gamed." An analogy with breaking out of prison is I believe, appropriate here. Just because we have not succeeded in gainfully regulating the market place doesn't mean there are regulatory tools that are available that have not been tried that would work against the gaming of the system. Having said that, I agree that the massive payments to individuals are the best way to accomplish the goal of economic recovery. Matching those however, I see a step zero that needs to be taken first to initialize the system for a recovery-a new infrastructure-one that looks better than the present -can we have some wilderness in our backyards for god's sake instead of relegating it to areas 700 miles out? Also can the urban sprawl with 1200 square miles of brick, mortar, glass, cement and pavement be contained? Destroying the ecological relationships around us to build urban areas is suicidal. Rebuilding the urban areas should include massive fiscal spending for cultural events (concerts of all genres, theater, movies, books, poetry, sculpture, architecture) mass transit and public housing. Again past failures in these endeavors can only point the way to future success. Once the individual safety net (public health care widely available with low cost clinics in every neighborhood) was nurtured, broadened and in general made much more muscular, the need for payments to individuals would eventually drop away as the difference in quality between privately owned property and public property fell away as the public aspect of life in its overall quality would rise well above anything all but very few individuals could afford.


Ray - I'm just saying that I'd rather live in a system that does not depend upon effective regulation to get the job done, especially given that we haven't seen it done since WW2.

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