How to Measure TARP's Success - Or Lack Thereof

by: Modeled Behavior

Arpit Gupta lays out a thoughtful commentary on TARP, concluding that it was a poor program. I don’t have a chance to address all of his concerns but let me push back on a few

First Gupta says:

The case that TARP was a successful program of equity injection is based on praise by association. TARP was passed; the financial sector seemed to revive itself; therefore TARP must have fixed the financial sector.

Yet it is impossible to causally trace the improvement of conditions in the financial sector to any one program. The federal government also implemented a number of other programs to ease conditions for financial firms — from increasing access to the Fed’s discount window (resulting in trillions of dollars of loans to insolvent institutions), to easing mark-to-market accounting rules that allowed banks to hide losses, to unprecedentedly low interest rates which allowed banks to accept cash deposits from customers while paying virtually nothing. The scale and scope of the federal government’s interventions in the banking sector were enormous, and TARP does not deserve the entire credit for turning things around.

This seems to be a common class of complaints. One cannot know that project X worked or not because there are confounding factors. This is true, but taking this objection too seriously leads only to nihilism. In government, in business, and in life, you only get one performance and there is no dress rehearsal. You can’t be sure that having your child provided satisfaction and meaning to your life; after all, you didn’t live a life where you didn’t have her.

Nonetheless, we have to make choices, including on how to go about rescuing a financial system. Sometimes, we want to take a step back and analyze how well those choices worked. Our basic strategy is to tell a narrative. This is how we think the world is working.

Both before and after our decision, we check back with our narrative to see if it is working. The narrative of some moving into Fall 2008 was that full-fledged bankruptcy of a broker-dealer would lead to chaos and perhaps a repeat of the Great Depression.

Then a broker-dealer went bankrupt. The process of chaos began to unfold. We had what looked very much like a run. Given that narrative, the response was to somehow stem the run. This meant insuring creditors against losses.

Various schemes were proposed; in the end, equity injections were settled upon. The terms were not what I would have wanted, but I understand the pressure of being in the moment.

After the equity injections, our measures of panic began to subside and indeed have not come back despite the fact that housing has not recovered. This lends credibility to those of us who said that housing and bad loans mattered only to the extent that they were possibly creating insolvency and fueling a run.

Do we know for sure that this is narrative is correct? No. However, the level of certainty I think Gupta is asking for is virtually never available to us in real time, and is hard to ascertain even looking back. My core case is that the narrative holds and continues to hold as we accumulate more data.

Second, Gupta says:

In other words — the government was not provided an adequate risk-compensated return [emphasis Gupta's]. In backing the American financial system, the Treasury Department took on an enormous financial gamble on behalf of the American taxpayer, one that could easily have gone bad. It is fortunate that things did, in fact, go well. But that doesn’t prove that the original risky gamble was sound; only that taxpayers were lucky, and under-compensated for their investment.

I am sympathetic to this view, though I take a slightly different tack. I tend to think that the government should have simply squeezed the financial system for everything that it was worth, on the grounds that it's the responsibility of the Treasury Secretary to act in the best interest of his clients. The taxpayers were his clients. Making more money for your clients is generally preferable to making less; thus, he should have tried to make more money.

However, it is important to note that TARP as structured was profitable on the bank side. It wasn’t simply that the taxpayer got his or her money back. There were warrants that gave the taxpayers a bit of the upside. I just don’t think they were big enough.

Also -- and this is another conversation – I think the caps on executive pay and other restrictions were awful and led banks to pay money back too soon. This not only introduced unnecessary uncertainty but also cut the government's profits.

I understand the moral outrage and all, but my general take is that the government in this capacity should act to maximize taxpayer profits, not express taxpayer outrage. I realize that this is not a majority view.

Lastly:

In fact, Treasury was hardly the white knight of the crisis, working with distinction to do the (presumably unique) right thing in the face of the idiots in Congress. They actively shaped the narrative of what was going on; presented only the solutions they favored [emphasis mine]; and only saw legal obstacles as binding when they applied to policies they did not favor. They may well have been patriotic workaholics as well. That only suggests that no such agency, well-staffed though it may be, should assume that level of power or influence.

This is a common reaction, and I think had some validity before the evolution of the blogosphere. However, in today’s world you can look at what outsiders -- including some experts -- were saying at the time. It wasn’t as if the Treasury had everyone hoodwinked.

A number of people, myself included, responded immediately that the initial Treasury plan to buy assets was a horrible idea and should be replaced by the equity injections. This is what happened. However, the narrative flow did not come from the Treasury. It is not to say that the Treasury was listening to the blogosphere – including prominent voices like Paul Krugman's.

It is simply to say that this narrative wasn’t at the discretion of public officials in the same way as narratives of years past. Mainstream journalists may not feel comfortable pointedly saying, "Look, either I understand finance better than Hank Paulson, or Hank is pulling a fast one" -- but many bloggers do.

I don’t mean this post to be a complete defense of TARP. I am a great fan of the program, but a full defense would probably require a book. The point that I want to repeatedly make is that what happened during a time that looked a hell of a lot like the moment of truth was that a group of bureaucrats and politicians pulled off a plan that was wildly unpopular -- and is sure to haunt them -- but that fit with the strongest narrative of how to save the country.