system
Given the following post, respond as if you're commenting on Reddit:
human
Where did the economic theory of bank bailouts come from?

....or was it just a reaction?  Is there sound reasoning behind a bailout?
gpt
We actually know really well what happens if you don't do bank bailouts, and the results are often catastrophic. Most modern economies are built on banks - contrary to popular belief, the main product of a bank (and other investors) is not money, it's actually risk. A bank takes on risk (through loans) from companies, and by pooling and aggregating multiple unrelated risks, essentially converts high risk investments into low risk investments. 

You can test this yourself through a simple experiment - imagine you have $50 to your name and a lottery gives you a 50% chance to go completely bankrupt or a 50% chance to have $150. It's actually a decent investment and would be good for the economy, with an expected return of ($150 - $50)/2 = $50, or 100% return. But most people wouldn't take that risk because a 50% chance of going completely bankrupt is pretty scary. But if you could do 1% of that investment over 100 investments, you pretty much now have a guaranteed chance of making that 100% return. Since these investments are now lower risk, you can also do more of them by borrowing from other people at anything lower than 100% - a process called leverage. Multiply this over an entire economy, and that's basically the job of a bank, an investor, an insurance company, etc. They "borrow" money from depositors, governments, other banks etc and then deploy that money into investments that then enable economies to grow and develop.

So in an economy where the risks have been pooled and leveraged, banks all systematically going under is basically the same as unwinding all the risk reduction all at once across a huge section of the economy. Savings get wiped out, businesses can no longer make investments or even normal day to day expenditure, and the normal risk which would otherwise have been easily solved by banks suddenly cause companies to collapse. The costs of this are immense, a basic rule of thumb being the wiping out of 20% of a country's GDP, and can take years to resolve. Bailing out the banks is much cheaper, and more importantly, much smoother for the general economy - actually leading to greater equality over the long run as well.

One key case study was the Showa Crisis in 1927. The Japanese government had issued a lot of specially discounted bonds to the banks in the wake of the Kanto earthquake which had been one of the world's largest catastrophes. For a variety of political reasons (mostly people thought the banks were profiting from the earthquake), they decided to reclaim those bonds, which made people think the banks might collapse. As people withdrew their savings, the banks actually did start to collapse, in a vicious self-fulfilling prophecy. The Prime Minister attempted to save those banks but was blocked by the Privy Council, and forced to resign. The crisis completely kneecapped the Japanese economy, most people lost 50% of their savings, until the new Prime Minister was forced to bail them out anyway to stabilise the economy. The bigger problem was that the new economy that emerged from this was highly uncompetitive - only the largest companies had managed to survive, coalescing around 10 or so gigantic conglomerates known as zaibatsu which owned 50% of the entire Japanese economy.

Since then, governments have generally not allowed large banks to collapse because of how horrific the outcomes have been. That being said, bailing out the banks results in something called moral hazard, where the benefits of banks taking outsized risks are accrued to the banks and their investors, but the costs are borne by the government and general public. This is a perverse incentive for banks to take on more risk than they should.