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Too Big To Fail

by Elaine Schwartz    •    May 25, 2011    •    238 Views

The HBO documentary, “Too Big To Fail” was excellent. But what to come away with?

TBTF (Too Big To Fail) solves problems and it creates them.

TBTF can reverse a confidence crisis. When the world is worried that the failure of a large bank will catastrophically ripple from one institution to the next until all financial markets are frozen, TBTF can solve the problem.

However, TBTF distorts financial behavior. Without TBTF, for chancy loans and risky projects, creditors provide less funding and ask for higher returns. With TBTF, by diminishing risk, the creditors’ incentives change. Consequently, it is much easier to fund speculative ventures that might endanger the institution. 

In other words, TBIF creates the very problem that it solves!

Here, during an Econtalk interview, economists discuss TBTF. Also, the book, Too Big To Fail, by a former Federal Reserve president and vice president provides considerable insight. A third resource is the book on which the HBO documentary was based, Andrew Ross Sorkin’s Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System–and Themselves.

The Economic Lesson

In 1781, Alexander Hamilton said that, “Banks…have proved to be the happiest engines that ever were invented for advancing trade.” In 1791, primarily because of Alexander Hamilton, the first Secretary of the Treasury, the First Bank of the United States was established by the U.S. Congress.

With only 3 banks in the entire country, Hamilton believed more could be done to expedite U.S. economic development. His goal was to have more money circulating that businesses, consumers, and government could use. As a powerful and large financial intermediary, the bank achieved his objectives.

An Economic Question: Looking at 1791 and 2011, explain why borrowing is important for economic activity.

 

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