We have previously examined how the banking system largely
suppresses creative destruction. Governments have generally kept banks who are
“too
big to fail” alive when they face financial turmoil. Nevertheless, there
are a few examples where banks were allowed to fail.
The Lehman
Brothers is one of the most notable big bank failures. One of
the world’s largest banks, it and its possible acquirers (Barclays) failed to
receive financial aid to save the firm. However, this example does not
represent some perfect free-market epiphany by the US government. Phillip
Swagel details other problems with life support for Lehman which confirms
this. In fact, Henry Paulson and the Treasury were actually pushing for Lehman
to be saved, but British regulators inflicted the final blow by blocking such
action.
Lessons from Iceland
Iceland
is a prime proponent to some form of creative destruction. They refused to
bailout the banks and furthermore, did not hold back on indicting those responsible
of financial crime. Following the crisis, Iceland’s indicators were much more
positive than fellow victims of the crisis, such as Ireland,
who did bailout their banks.
“Why are the banks
considered to be the holy churches of the modern economy? Why are private banks
not like airlines and telecommunication companies and allowed to go bankrupt if
they have been run in an irresponsible way?” Ólafur Ragnar Grímsson, President
of Iceland
Iceland’s actions could have been viewed as madness but,
evidently, there was some method behind this. Not only are bailouts a violation
of free markets, they also create moral hazard. What is to
stop banks from continuing to feed their appetite for risk if they know there
is a safety net to catch them if they fail again? There is a catalogue of
papers whose inferences indicate economically significant correlations between
risk-taking and higher bailout belief; Kim, Y.
(2013) and Dam,
L. & Koetter, M. (2012) to name a few.
The Economist (2010)
The above graph is one such statistic that somewhat proves the worth of creative destruction. To verify this, we must ask what made Iceland so special, and why is this not a much more widely adopted method?
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