On the sunny, chilly morning of January 20, 1981, as the country faced crippling double-digit inflation and a smoldering banking crisis, Ronald Reagan swore the oath to become the nation’s 40th president. “Government is not the solution to our problem, government is the problem,” he famously pronounced.
Reagan was right, but not as he intended: over two terms, his White House, with the active participation of his vice president, George W. Bush, would hide the extent of the bank crisis from the American people, and, in the process, render what was initially a $50 billion problem into one that would cost 10 times more to fix. Reagan rode into office promising lower taxes and less government, but his administration’s poorly executed implementation of the latter led to the most expensive bailout in US financial history. The bailouts during the Great Recession in 2008 totaled in the trillions—$24 trillion by one reckoning—but because most was repaid or not used, the bailout during the 1980s bank crisis retains the title as most expensive for taxpayers.
At the heart of the 1980s crisis was federal deposit insurance, which the US Congress had enacted 50 years earlier during the Great Depression, despite initial objections from President Franklin Delano Roosevelt. It works like this: Banks pay an insurance premium into a federal fund that guarantees that, if a bank fails, depositors will receive their deposits up to a specified amount—when adopted in 1933 it was $2,500, today it is $250,000. If the premiums banks pay into the fund prove insufficient during a time of economic crisis, taxpayers must fill the gap.
Roosevelt agreed that deposit insurance would stop the bank runs plaguing the country but argued it also would create moral hazard in depositors, who, knowing their money was safe no matter what, would become indifferent to whether bank executives ran institutions safely or not. He proved to be correct. During the 1980s bank crisis, Reagan allowed hundreds of insolvent banks to remain open. The sicker these institutions became, the more incentive they had to find cash that they could invest in high-risk but potentially high-return ventures—and possibly grow out of their troubles. To raise this cash, the banks paid higher-than-market interest rates. Depositors, knowing they would be paid no matter how risky the banks’ behavior was, flocked to put money into them. The high-risk gambling failed, and banks became ever more insolvent.