The biggest lesson from Europe

Six central banks -- the ECB, the US Fed, the Bank of England, the Bank of Japan, the Bank of Canada, and the Swiss National Bank -- rushed in to the European crisis today by taking steps to ensure liquidity for banks (essentially, lowering the cost of lending backstops that European banks can use as a source for short-term liquidity).

This was obviously a coordinated plan that had been prepared beforehand, probably for use in the event of real emergency (the collapse of a major European bank, for example, as Jim Cramer speculated this morning on CNBC). It is thus another example of "too big to fail" in all likelihood.

Before anyone explodes in anger at yet another example of those now-hated words (which have become so well-known that they are sometimes simply abbreviated TBTF without needing explanation), let's ask a few questions about why too big to fail has become the order of the day.

There is a line of argument which says that no bank should be "too big to fail," and that if banks make stupid loans, they should pay the price and go bankrupt if those loans don't pan out. After all, if those loans do work out, the banks get the profit, so why should they get the profit when their risky loans turn out well, but spread the cost of their failure to everyone who pays taxes, or to everyone who is forced to use a currency that is devalued over time?

However, there is a problem with this line of argument. For one thing, there is the moral problem that arises from the fact that the banks were often forced into making some of those risky loans in the first place (by governments, who have plenty of leverage over banks and can make life unbearable for them if they don't make loans to people or countries that the government wants the banks to loan to).

You can decide for yourself if it seems right for governments to coerce banks into making risky loans, and then to stand back when the loans go sour and shake their heads and say, "Well, I guess you never should have made those risky loans -- now you have to pay the price, by the laws of the free market!" We can look back in recent history and see plenty of examples that follow the same exact pattern.

Everyone in the US is angry that the government "bailed out" banks who held lots of subprime mortgage securities, but the citizens shouldn't be too angry, since they elected the government officials who passed laws forcing banks to loan to less-than-creditworthy borrowers (Congressman Barney Frank, who recently announced his retirement, was one of the primary culprits in pressuring the banks to loan to borrowers they would not otherwise loan to, and he will be replaced as the ranking member of the House Financial Services Committee by Representative Maxine Waters, who was just as aggressive).

Similarly, during the Latin American debt crisis of the 1980s, US banks had been told by the US government to lend at below-market rates to Latin American nations such as Mexico, Brazil and Argentina. When those countries found that their income (in the form of taxes, which come from the earning power of their businesses and the earning power of their citizens) was not enough to pay for the interest on the debt they had racked up, it would not have been right for the US government to simply let those banks swing as a penalty for lending to risky borrowers. They were forced to lend to those risky borrowers.

The same scenario is now playing out in Europe.

Further, while it does impress some people to talk tough and say, "I wouldn't lift a finger to help these banks -- they need to learn their lesson," the problem is that "teaching the banks a lesson" could entail collateral damage that goes far beyond the banks and causes severe harm to many innocent bystanders. Is "teaching the banks a lesson" worth the risk that ordinary citizens might be unable to access money that they have in money market funds for an unknown period of time, for example? If ordinary citizens can't access their money, it would cause all kinds of disastrous problems for families and small businesses. Is that a worthwhile price to pay in order to "teach those banks a lesson" about loaning to risky borrowers (especially when the government made those banks make a lot of those loans in the first place)?

To take this position is almost equivalent to saying, "If kids are playing with matches, you have to let them burn down the house sometimes -- it teaches them a lesson -- and that's just tough if they get burned to death in the process, along with a few of the neighbors."

The bottom line of all this is the fact that "you can't have just a little bit of socialism."

When governments interfere with banking, even if it's just a little bit, it eventually results in situations just like the one that is unfolding right now in Europe. First, the government meddling tends to result in expanded lending activity to borrowers who would not otherwise get loans (and at terms that those borrowers would never be able to get under a purely "free market" situation). This happens both because governments feel they can tell banks to whom they should loan and also because banks become more willing to lend to people or governments they would not otherwise lend to, as long as the government promises to pick up the tab if those loans don't work out (have a look at our previous post on the Solyndra debacle, for a recent example).

After the first result (expanded lending to people and/or governments who would otherwise not get loans, or who would otherwise have to pay a lot more for those loans), the second result is rather obvious. When all that artificially-expanded credit begins to go sour, the government sails in with other people's money in order to prevent the whole house from burning down. Once even a "little bit of socialism" gets added to banking, TBTF becomes an inevitable acronym of banking.

The sad fact of the matter is this: there is a market rate for borrowing that is based on creditworthiness, and if you want to subvert that rate, you will end up with inevitable losses. Loaning lots of money to people or nations with terrible credit histories will always mean that some of it is lost, and if you don't charge them high enough rates to cover those losses, you will have to get the money from someone else to cover those losses. The place that governments get that money is obviously from everybody else, either in the form of higher taxes or in the form of inflation and the slow loss of their purchasing power over time, or both. As Milton Friedman famously said numerous times, in economics there is no free lunch.

Yesterday we published a post about some other lessons from the current European crisis, but we believe the topic of this post is the biggest lesson out of the entire European situation. We have been talking about today's action which was probably taken to prevent a bank failure, but the question of government involvement in banking, lending, and bailing out is related to what we have called "the question of our time," because bloated spending by governments is directly connected to easy credit and borrowing, interference in banking, and ultimately the devaluation of currency. The pensions and other government entitlements that some Europeans have been enjoying on borrowed money are now going to be paid for by everyone else, but this should not come as a surprise.

Once people, through their elected leaders, decide to abandon the principles of free market capitalism, the socialization of losses and "too big to fail" become inevitable consequences. Everyone pays.