The economics of “bailouts”

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."


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