“Capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.” – James Grant, Grant’s Interest Rate Observer
When the deregulation of the banking industry took place under the Clinton administration, it was not completely deregulated; the principle part which was not deregulated was the piece leaving the taxpayers on the hook to absorb bank failures.
When the credit markets came near to collapse in the fall of 2008, the Federal government had a basic decision to make: try to save the banks and credit markets, or let them fail. A major part of the calculation to try to save the banks was that if the banks failed then the taxpayers would be responsible for trillions of dollars in insured deposits. To put it bluntly, the Federal government did not have the necessary trillions of dollars on hand that would have been required by law.
Consequently the decision was made to re-inflate the real estate markets that the CDS devices were dependent on in order to save the derivative markets and from there save the credit markets. This was accomplished by the zero interest rate policy, liquidity injections, the Federal Reserve buying distressed assets from banks and corporations, and a host of other activities. Along the way the Federal Reserve also took an activist role in re-inflating the stock markets. There are even unsubstantiated rumors that the Federal Reserve directly purchased stock shares in order to elevate the equity markets.
In doing all of this, the Federal government and Federal Reserve implicitly and explicitly communicated that they would not allow these markets to fail or suffer a sharp decline that might adversely affect confidence in the markets. The unintended side effect of this policy has been that the real estate and equity markets have become risk free, since investors do not believe the Feds will allow them to suffer a loss. As such, the economy is now like socialism for rich people: the Feds have promised to socialize the losses among the American citizens but allow the profits to be kept by the entity that is investing in these markets.
Money that should have been allocated to new products, new services, and new jobs has been redirected into stocks and real estate.
The Federal Reserve and Federal government by and large are populated by intelligent people. They understand that they cannot continue this forever without very adverse effects on the economy. In fact, we see those very adverse effects already in the lack of full time private sector employment, wage stagnation, ever increasing debt of all types, and bubbles in real estate and equities. The Feds know that if they continue these policies, these negative consequences will only grow. The trick is how to escape the consequences without doing the very thing they set out to avoid: crashing the world credit markets.
The Feds have created an extraordinarily distorted market with at least tens and perhaps hundreds of trillions of dollars in misallocated capital. For example, when the crisis first hit in September of 2008, the worldwide notional value of derivatives was about $240trillion. The current worldwide notional value of derivatives is about $550trillion. With the Feds placating the credit markets, the amount of money invested in these instruments is more than double what it was when the crisis hit. The cure may have alleviated the pain the patient was feeling but ultimately it made the illness much worse than it otherwise would have been.
On top of all of this, the taxpayers are still on the hook if the banks fail.