The economics of “bailouts”

by on March 19, 2008 at 6:24 am in Economics | Permalink

Paul Krugman writes:

…(according to Reinhart and Rogoff) the resolution of Sweden’s financial crisis imposed a fiscal burden – that is, required a taxpayer-financed bailout – equal to 6 percent of GDP. That would be $850 billion in America today. Just saying.

It’s worth noting that such costs consist mostly of transfers rather than real resource costs.  Most of the costs of overinvestment in housing already have been borne in the form of lower living standards, namely we have fewer non-housing goods and services.  Making debt obligations whole again does involve higher taxes but most of the money is sloshed around; the government doesn’t dynamite any factories or homes.  It should bother you if you think taxes are already too high but of course that doesn’t describe everyone.  Furthermore if the destruction of the debt claim would otherwise have been deflationary, some of that debt can be monetized (thus, taxes don’t go up) without raising the risk of inflation.  (TC: the Swedish number seems to be wrong, see the first comment.)

Here are a few other points about bailouts, or non-bailouts, as the case may be:

1. Most plans for Fed assistance aren’t bailouts at all.  It is pretty easy for the Fed or Treasury to virtually wipe out shareholders.  The real "bailouts" come when the institutions are allowed to stay open and continue taking risks.

2. The Fed’s regulatory powers make crisis deals less than fair.  If you, as a bank, don’t accept the Fed’s terms, you can be prosecuted or thrown in jail or at least ruined by your friendly regulator.  Being an advocate of the rule of law, I’m not entirely comfortable with this arrangement, but it does mean that the Fed has a much easier time managing crises. Keep in mind also that the failing banks are indeed the most likely ones to have been criminal, so the unfairness is not usually being applied to the innocent.

3. If you think the managers were in charge, and will remain in charge, the real moral hazard problem is the severance pay for the failed managers, not the so-called bailouts.

4. If you’re a critic of bailouts, you can’t have it both ways.  If the Fed or Treasury is guaranteeing loans, yes that does put taxpayer dollars on the line.  But if you think the system can hold up, as do most bailout critics, those guarantees are unlikely to cost very much.  The Fed or Treasury may even turn a profit.  If you think the system cannot hold up, the bailout is probably necessary even if costly.  So you can’t claim: "The bailout isn’t needed" and also "The bailout will burden taxpayers." 

Addendum: By the way, do read David Leonhardt on "what really happened."

Joe Torben March 19, 2008 at 9:07 am

The figure of 6% of GDP for the bailout of the Swedish banks is incorrect. There is no reference to it in the Reinhart & Rogoff paper. It was estimated that the worst case cost at the time could end up at about SEK 100 bln, which was roughly 6% of GDP. In the actual case, the costs were much, much lower. Only Gotabanken failed, and Nordbanken (subsequently Nordea) was nationalised. It recovered quickly and has since been partly privatized. In the end, it is probably that the Swedish government will make more from selling the outstanding shares of Nordea than they paid for the whole mess in the first place.

If so, that would then put the cost at 0% of GDP. (This doesn’t mean that governments should do stuff like this at will – the government took on a huge risk. It’s just that in this particular instance, it didn’t happen to cost the taxpayers anything.)

Anthony March 19, 2008 at 9:58 am

“If you’re a critic of bailouts, you can’t have it both ways. If the Fed or Treasury is guaranteeing loans, yes that does put taxpayer dollars on the line. But if you think the system can hold up, as do most bailout critics, those guarantees are unlikely to cost very much. The Fed or Treasury may even turn a profit. If you think the system cannot hold up, the bailout is probably necessary even if costly.”

There are a certain set of facts which allows you to have it both ways. If Bear Stearns turns out to be insolvent, and “the system” could withstand a standard court-approved liquidation of its assets, then this is a bailout, of Bear Stearns’ creditors, and it is unnecessary.

The first half of that hypothetical is something we will likely find out eventually. The second half is something I personally don’t have much of a handle on, so any arguments you can provide or point to in that regard would be much more useful than just asserting it as a fact. But even if “the system” would have failed in the absence of *any* government intervention, could the Fed have targeted its intervention to those victims more innocent than Bear’s creditors?

Isaac March 19, 2008 at 11:29 am

The first comment is wrong: the Reinhart Rogoff paper does reference the number, see page 4, footnote 1.

Erik March 19, 2008 at 1:38 pm

“The first comment is wrong: the Reinhart Rogoff paper does reference the number, see page 4, footnote 1.”

That is incorrect. There is no reference in that footnote, even though discuss the number they state in the main text.

Ryan March 19, 2008 at 3:24 pm

My question is, why can’t we design a system that doesn’t need to be bailed out so often? I’m thinking of a more decentralized system, like the internet, which is designed to withstand the failure of large sections of its network.

N-z March 20, 2008 at 4:48 am

“Furthermore if the destruction of the debt claim would otherwise have been deflationary, some of that debt can be monetized (thus, taxes don’t go up) without raising the risk of inflation.”

So – if we assume that debt deflation is unnacceptable and that losses should not be realised we can monetize debt to a large degree with no inflationary effects. Ok, let’s assume I accept that argument. I remain fundamentally confused as to why the banks / wealthy investors in hedge funds should be the principle beneficiaries of the Fed’s pseudo-monetization (lax repos which get rolled over, TAF, etc). I would think it would be more ‘democratic’ to credit, say, the poorest 20% of Americans with tens of thousands of dollars directly into their bank accounts. Whether you agree or not with this thought experiement is not really the issue – I guess my point is there are philosophical reasons to be opposed to monetization. Fairness is the issue here with bailouts.

Unfairness could eventually lead to a loss of confidence in the currency itself on a psychological basis or a backlash manifesting itself as ridiculously populist demands placed upon the government, amongst other possible consequences. Maybe its unlikely monetization would unravel in this way because the common man doesn’t understand it. But let’s be clear about the philosophical problems and the risks.

And this is coming from someone who works at a major i-bank and benefits greatly from the Cantillon effects of money creation happening at my doorstep.

richard lilliston March 31, 2008 at 11:26 am

To bailout or not to bailout. That is the question. In both cases those with mortgages they can’t afford for homes that are not worth what they paid are in real trouble. Let’s bail them out and let the perpetrators go under. Bear Stearns and their ilk need to take responsibilty for poor fiscal management. We keep bailing them out and they keep coming back like the living dead. Let them die a natrual death, diminsh the gene pool so to speak, and let them all know in the future there is no bailout. By the way, why is it that none of them is complaining aobut regulation during this “regulatory bailout?”

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