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Bailouts: Public Money, Private Profit
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Introduction: To Bail or Not to Bail?
Robert E. Wright
The verb "to bail out" means to implement a bailout. The noun "bailout," in this volume and I believe more generally, refers to instances when the government aids one or more economically distressed businesses in some way. Big picture, bailouts are simply one of many forms of government interaction with the economy and the producers and consumers that inhabit it. Governments proscribe certain activities—or at least attempt to. For example, they try to ban the production, sale, or use of certain chemicals, like LSD and crystal meth. They sometimes try merely to discourage consumption of certain goods, like gasoline, by taxing them or otherwise raising their cost, for instance by restricting the places where tobacco can be lawfully smoked. Governments also try to encourage certain behaviors through tax incentives and sundry sorts of subsidies. In the United States, for example, the Department of Defense directly aided over 3,600 defense contractors between 1958 and 1973, and since the Depression, the Department of Agriculture has plied farmers with billions of dollars in cash aid and subsidized loans. Almost invariably, governments claim to interact with the economy to improve it in some way. Often, however, government oªcials implement policies at least partially designed to fatten their own wallets or, in less corrupt nations, to enhance their electoral prospects by bestowing favors upon influential groups, like labor unions and major corporations.
Governments also try to manage macroeconomic outcomes, including per capita output and unemployment, exchange, interest, and inflation rates. Whenever an unexpected shock, like a natural catastrophe, terrorist attack, or financial crisis, threatens economic growth or employment levels, the a¤ected government comes under pressure, domestic and international, to respond. Often, governments try to bail out distressed firms in the hope of maintaining employment and output. Bailouts seem like common sense until we realize that they are costly and may not produce the desired e¤ect. Some, perhaps most, bailouts initiated in response to financial crises redistribute resources, often from the innocent and poor to the blameworthy rich, without speeding the return to economic prosperity and are actually planting the seeds of the next crisis. Yet the failure to bail out could cause a protracted economic downturn that would hurt everyone, but most especially the poor, aged, unskilled, and otherwise vulnerable.
To bail or not to bail is the Shakespearian question that confronts Americans today, and it does not admit of an easy answer. On the one hand, people fear that if the government does not respond to the financial crisis with vigor, another Great Depression may bring back bread lines; desperately squalid mothers pining for the well-being of their dirty, shack-dwelling children; and Rose of Sharon Joad suckling a starving man in a barn with the breast milk nature intended for her stillborn child. Route 66 may again be cluttered with old cars, only this time the exodus will be from a parched and over-farmed California, not to it. On the other hand, Americans also fear that bailouts unfairly reward risky behavior; take money out of their pockets for the benefit of the rich, the dumb, and the greedy; and may not get the economy growing again. A few even suspect that bailouts can turn a recession into a depression by interfering with normal market mechanisms.
Americans’ fears are well justified. Government inaction could allow a bad situation to get worse, but so too could an overzealous government reaction. Narratives of the Great Depression make both claims. Some bash Herbert Hoover for sitting on his hands, while others blame government interference, including the Smoot-Hawley tariff, a bumbling Federal Reserve, and disruptive New Deal policies, for transforming a natural downturn into an international calamity.
Both stories are in some sense right. The key to vitiating any systemic crisis, as the contributors to this volume see it, is for government to implement just the right type of bailout. Discerning what policy or policies that entails, however, is far from clear. Theory is of limited use here, we believe. What ultimately matters is reality, which prompts us to ask empirical questions like: What are financial crises and what causes them? What is a bailout? What types of bailouts have been tried? When, where, and why? Did they aid the economy and by what measure? If so, why? If not, why not? What unintended consequences or side e¤ects can bailouts cause?
The authors of the chapters in this volume address those questions through the lenses of history and statistics. They do not always agree on the details, but their conclusions point in the same direction. Di¤erent types or degrees of crises demand different types of bailouts. Context is crucial. In the late 1980s and early 1990s, for example, the creation of a so-called bad bank, the Resolution Trust Corporation, worked fairly well to resolve a crisis of insolvent savings and loans. The same approach, however, may not work to end the current crisis, which has struck a relatively few large, complex financial institutions and not, as in the 1980s, hundreds of smallish depository institutions.
If carefully chosen and implemented, bailouts can slow or even stop further economic deterioration by restoring order to markets and confidence to businesses and investors. There is no statistical evidence, however, that bailouts can speed economic recovery. In fact, bailouts can slow recovery by creating policy uncertainty, distorting market incentives, and in extreme cases fomenting sociopolitical unrest. Contrary to common perception, the U.S. government does not bail out every distressed industry that asks it for aid. To date, its bailouts have been directed toward the financial system, the proper functioning of which most experts agree is crucial to economic stability, large industries like railroads and automobile manufacturing, and broad segments of the population, including taxpayers and homeowners. Nevertheless, the redistributive aspects of bailouts continue to cause considerable consternation for citizens and lawmakers.
It is the redistributive qualities of bailouts that I focus on in the first chapter, "Hybrid Failures and Bailouts: Social Costs, Private Profits." Hyper-dysfunctional parts of the economy, including financial crises, are rooted in hybrid failures, or complex combinations of both market failures, like asymmetric information, externalities, public goods, and asset bubbles, and government failures, like inadequate or inappropriate regulation and distortions caused by the tax system and social engineering. In that sense, crises are caused by complex societal forces, and hence a social response to them is both warranted and justified. On the other hand, some types of bailouts are clearly unjustified because they enable private concerns (individuals, corporations, entire industries) to take one-sided bets where they earn private profits when conditions are good but impose losses on society when conditions are bad. That arrangement exacerbates moral hazard or unjustified risk taking, which in turn increases the likelihood and severity of crises. Taking resources from taxpayers to help stoke the fires of crisis is clearly not good policy.
What, then, to do? As a historian, I suggest that a policy akin to Hamilton’s Rule (formerly Bagehot’s Rule) would serve best. Treasury secretary Alexander Hamilton, like Walter Bagehot and other central banking theorists after him, showed during the Panic of 1792 that the government can thwart a financial panic by lending at a penalty rate to all borrowers who can post good collateral. The collateral requirement ensures that only safe firms receive aid. The penalty rate ensures that firms borrow from the government only as a last resort. The economic pain of borrowing at a high rate, even if it is just a percentage point or two above the usual level, limits moral hazard and risk taking. The rule also minimizes losses to taxpayers by requiring that loans be well collateralized and yield a good return. In fact, the government (and hence ultimately taxpayers) may actually profit from such policy implementation.
Some economists believe that Hamilton’s Rule can be applied e¤ectively internationally as well. That is an important consideration today due to globalization and the increasingly multinational scope of the world’s largest and most important financial and manufacturing enterprises. Historically, increased interconnectedness is associated with financial crises more global in nature because troubles in one country spread more easily to others. The Japanese banking crisis of the 1990s, for example, negatively impacted real economic activity in the United States because the impaired Japanese banks decreased the volume of their overseas lending, including commercial real estate lending in the United States. As a result, a "substantial decline in construction activity" in America took place. In the most recent crisis, the interconnection of national economies via multinational enterprises (MNEs) like General Motors and AIG is even more palpable and hence potentially politically disruptive. No matter how necessary to promote global economic stability, an international bailout that appeared to redistribute wealth from the poor of one country to the wealthy of another would be political dynamite. The limited risk of such a redistribution occurring due to the application of Hamilton’s Rule, relative to other types of bailouts, is therefore an important additional consideration.
Of course preventing domestic and international crises is preferable to fighting them, a point that banking economist Benton Gup emphasizes in the second chapter, "Financial Crises and Government Responses: Lessons Learned." Gup notes that many financial crises both in the United States and abroad have been caused by the bursting of real estate bubbles, the ill e¤ects of which metastasize to other parts of the financial system and the real economy. The effectiveness of common intervention techniques, including forbearance (doing nothing), provision of short-term liquidity (sometimes via Hamilton’s Rule, but more recently at lower rates for all), long-term debt investment, partial or total nationalization, and taxpayer-assisted liquidation, is limited by the fact that they address symptoms rather than causes. Gup persuasively argues that in the future governments should expend more resources trying to prevent crises in the first place by monitoring their typical causes, which include excess leverage, credit risk, interest rate risk, and improper securitization schemes.
In the third chapter, "The Evolution of the Reconstruction Finance Corporation as a Lender of Last Resort in the Great Depression," economist Joseph Mason provides a case study of a bailout gone somewhat but not completely awry. Like the Troubled Assets Relief Program (TARP) bailout created in 2008, the Reconstruction Finance Corporation (RFC) got off to a rocky start. Instead of lending liberally on good collateral as Hamilton’s Rule (then known as Bagehot’s Rule) suggested, the RFC in 1932, its first year of operation, made loans only to big businesses. Meanwhile the Federal Reserve (the Fed), hampered by the gold standard and its own ideology, also failed to aid safe but liquidity-constrained firms. Both the Fed and the RFC su¤ered from political squabbling and internecine conflicts, particularly between their New York and Chicago factions.
The public did not like the RFC’s conservative lending policies, so its mission was revised in a July 1932 law. The interest rate it charged was lowered, the collateral it demanded relaxed, and its mandate was expanded to include infrastructure projects and exports. The changes, however, did not help the agency stop a major rash of bank failures that fall and in early 1933. Later in 1933, new emergency legislation empowered the RFC to purchase preferred shares and debentures, which helped it to liquidate over 4,000 failed banks and to get almost 13,500 banks into good enough shape to obtain deposit insurance through the new Federal Deposit Insurance Corporation (FDIC) in 1934. By 1935, the RFC had transferred primary responsibility for banking policy to the FDIC and began to wind down its operations, a long process drawn out further by a remissioning prompted by the government’s mobilization for World War II.
Ultimately, the RFC’s precise role in resurrecting the U.S. economy in the mid 1930s, if any, is impossible to discern because its specific effects cannot be isolated from those of other New Deal bailouts or the economy’s natural resilience. A case can be made, however, that it aided recovery to the extent that it sped up the liquidation of failed banks and prevented additional bank failures. Injections of equity capital through preferred stock purchases worked well in this and other instances and did not unduly burden taxpayers.
In the fourth and final chapter, "After the Storm: The Long-Run Impact of Bank Bailouts," political scientists Guillermo Rosas and Nathan Jensen show that the ambiguity of the RFC’s aid is typical of recent government bailouts worldwide. After conducting various statistical analyses, Rosas and Jensen conclude that they cannot reject the hypothesis that government bank bailouts worldwide since 1970 have not sped economic recovery. Ascertaining the e¤ects of bailouts on economic output is not an easy exercise, so they are careful not to overdraw their conclusions. Nevertheless, their inability to find compelling statistical evidence of the economic eªcacy of bailouts should give policymakers pause. To bail or not to bail is as legitimate a policy question as how to bail out is.
BAILOUTS AND THE CAUSES OF THE CURRENT CRISIS
The devolution of the subprime mortgage crisis of 2007 into the systemic financial crisis of 2008 induced the U.S. government to bail out the financial system and to a lesser extent automakers, taxpayers, and homeowners. Its scattergun approach evinces politicians’ natural predisposition to appease as many major constituencies as possible but also reflects a sort of intellectual abyss. The causes of the financial crisis are hotly debated and, if ongoing debates regarding the causes of the Great Depression are any indication, will likely continue to be for years and possibly decades to come. Unfortunately, most discussions are highly, some might say ferociously, partisan. All agree, more or less, about what happened and when. A clear narrative explaining why those events took place, however, remains elusive. That void renders it diªcult to create a consensus regarding bailout policy.
Home prices had been rising steadily since the late 1990s but in 2003 began to increase rapidly in markets like Manhattan, Miami, and Southern California. At the same time, banks using new financial techniques greatly expanded mortgage lending to so-called subprime borrowers, individuals who traditionally would not have been able to purchase their homes due to insufficient income, collateral, and/or employment or credit history. Many of the mortgages contained new (or newly rediscovered) features, like interest-only and teaser interest rates scheduled to reset to higher rates in a few years. Soon speculators began taking out subprime mortgages as well, to finance houses they hoped to "flip," or resell, for a profit after a short period. When housing prices were rising, subprime mortgages appeared benign instruments that enriched poor households, real estate speculators, and lenders. Cheap refinancing terms meant that most people who got into trouble could get out of it, at least temporarily, by taking out a new, larger mortgage or adding a second mortgage to an existing one. When housing prices flattened and eventually reversed, however, many of the borrowers defaulted. The poor found it difficult to make payments when the prices of gasoline and other necessities were soaring and easy refinancing disappeared. Speculators found themselves "underwater," owing more on their mortgages than their speculative purchases were worth. The non-performing loans hurt lenders and, through derivatives like mortgage-backed securities, eventually diminished the wealth of numerous investors worldwide.
That caused banks and other lenders to restrict new lending, which ironically led to layo¤s and ultimately to more defaults. In 2008, the weight of numerous defaults led to the failure of several financial companies (Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual) large and important enough to spark the deepest and most widespread financial panic since the Great Depression.
Why those events occurred depends on who you ask. Generally speaking, liberals blame the market, while conservatives lambaste the government. Democrats point to Republican policies, and Republicans claim all fault falls on Democratic initiatives. Further complicating the narrative are various fringe groups grinding away at their favorite axes, like the "culture of consumption" and "greed." No single narrative of the crisis will satisfy all readers, but I hope in chapter 1 to transcend the current debate by describing its deep historical and theoretical roots. Here, my goal is the more modest but still formidable one of narrating the causes of the crisis from the standpoints of the Left (liberals, Democrats, statists) and the Right (conservatives, Republicans, libertarians). Both accounts are amalgams, my interpretations of comments made by scores of bloggers, columnists, policymakers, and TV and talk radio pundits on both sides of the aisle, and not the views of any particular persons or groups. No part of either narrative is necessarily wrong in any absolute sense, but in chapter 1, I’ll show that viewing the causes of the crisis through a partisan lens is bound to make you miss much of importance—like the crucial role that perverse economic incentives played at the borrower-lender nexus—and conflate cause, background condition, and effect.
From the Left, the financial crisis appears to have been rooted in the actions of unscrupulous financiers who persuaded Congress and presidents Bill Clinton and George W. Bush to deregulate the financial system. Specifically, financiers won repeal of Glass-Steagall, crucial New Deal legislation that separated investment banks (which engage in securities issuance and brokerage and coordinate corporate merger and acquisition activities) from commercial banks (which take deposits and make loans). They also changed arcane accounting rules to make it easier to hide their liabilities in off-balance-sheet entities like the notorious SIVs (special investment vehicles). Wall Street megabanks also successfully blocked the Commodity Futures Trade Commission from regulating financial derivatives that became the basis for massive speculation (risk taking). Those same plutocrats co-opted the Securities and Exchange Commission (SEC), thus undermining another piece of New Deal wisdom that had played a crucial role in maintaining postwar financial and economic stability. Big bankers also managed to cajole global regulators into allowing them to determine their own capital reserve requirements based on their own internal risk assessment models, a practice much akin to hiring a hungry fox to guard a henhouse. Perhaps worst of all, regulators allowed lenders to systematically exploit poor, defenseless borrowers by foisting upon them mortgages and other types of loans that the borrowers could hardly be expected to understand much less repay. Unregulated private mortgage giants Fannie Mae and Freddie Mac exacerbated the situation by aggressively expanding the traditional scope of their business into the subprime mortgage market. Widespread predatory lending practices ultimately undermined the mortgage-backed securities, collateralized mortgage obligations, collateralized debt obligations, and other unregulated derivatives the banks hid in their SIVs. Even as problem loans infected derivatives, which in turn caused massive write downs (accounting losses) at major banks, private credit-rating agencies like Standard and Poor’s and Moody’s overestimated the quality of mortgage-backed securities and of the firms issuing them, which began to fail in 2008.
To observers on the Right, by contrast, financiers fell victim to inane government regulations and monetary policies. Although once the darling of conservatives, former Federal Reserve chairman Alan Greenspan has been much maligned since the crisis began for keeping interest rates too low for too long toward the end of his tenure. (Apparently, the Right tolerates the Fed when the profits pour in, but when they evaporate at least some on the Right castigate America’s central bank as the last bastion of communistic central planning.) Loans contracted between consenting adults cannot be predatory; subprime borrowers could have/ should have known what they were getting into. Moreover, before the development of the mortgage-backed securities and off-balance-sheet entities that made subprime lending possible, the government punished banks, via regulations like the Community Reinvestment Act (CRA), for not lending to traditionally underserved groups, including the poor. Although the government did deregulate some aspects of finance, over-regulation remained the largest threat to the financial system’s efficient functioning. The SEC, other government regulators, and quasi-government regulators, like the GSEs (government-sponsored enterprises like Fannie and Freddie) and the cartelized and cloistered credit-rating agencies, had sufficient powers of oversight to rein in those few firms that pushed the risk envelope too far. If the market failed, it was for trusting that the massive government regulatory apparatus would do its job and maintain financial system stability. Its inability to do so was not factored into bankers’ risk models. Most important, regulators allowed Lehman Brothers to go bankrupt even though financiers had assumed the government would rescue a large, complex company as deeply integrated into a large number of important national and global financial markets as Lehman was. The government then exacerbated the inevitable market chaos that followed with counterproductive emergency measures, like bans on short-selling.
Given its belief that a bumbling government bureaucracy caused the crisis, the Right has naturally exuded more skepticism of the government’s bailout efforts, even those initiated by the Republican Bush administration, but some on the Left have also expressed doubts, particularly concerning issues of redistributive fairness. Nevertheless, the U.S. government to date (June 2009) has decided that the crisis warrants bailing out the financial system and domestic automobile manufacturers because both industries are "too big to fail." In other words, their sudden cessation of business would destabilize the economy and cause a systemic crisis that would have long-lasting adverse consequences for all. The fact that distressed financial firms received relatively more money, more quickly, and on easier terms than those o¤ered to Chrysler and General Motors (GM) indicates that policymakers believe that disruption of the financial system poses a substantially larger risk to macroeconomic stability. Many academic researchers concur, noting that financial firms are much more interconnected than manufacturers and provide basic services that few non-financial businesses or consumers can do without. It appears that such claims are correct, at least in this case. After extending short-term emergency loans to the troubled automakers, the government allowed Chrysler to file Chapter 11 bankruptcy on April 30, 2009, and at the time of writing was prepared to allow GM to reorganize under bankruptcy protection as well. The automakers’ troubles have led to widespread layo¤s at factories and dealerships but have yet to precipitate anything like the panic that gripped the world’s financial markets immediately following the bankruptcy of Lehman Brothers on September 15, 2008.
Prior to the fateful decision to allow Lehman to file Chapter 11, the government had underwritten JPMorgan Chase’s acquisition of failed investment bank Bear Stearns in mid March 2008, attempted to stimulate the economy over the summer by returning $168 billion to American taxpayers, and on September 6 nationalized giant mortgage banks Fannie Mae and Freddie Mac. Within days after the disruptions caused by the failure of Lehman, the government began to pour what would eventually be over $100 billion into troubled insurer AIG. It also allowed investment banks Goldman Sachs and Morgan Stanley to become bank holding companies so they could obtain emergency liquidity loans from the Federal Reserve. By the end of September, the government had also seized and sold the assets of failed banking giant Washington Mutual to JPMorgan Chase and sketched out an emergency economic stabilization act. After some politically inspired dithering that sent the stock market into a deep downward slide, Congress finally approved the act, and President Bush signed it into law on October 3. The law created the Troubled Asset Relief Program (TARP), a controversial measure initially designed to allow the government to purchase underperforming mortgage-backed securities and other so-called toxic assets. After that plan proved untenable, the government used TARP money to recapitalize banks, many of which partook of the cheap funds until the government began attaching strings to them. The government is also attempting to extend some relief directly to distressed mortgage borrowers, but thus far its e¤orts in this area have been relatively small and ineffectual.
Meanwhile, the Federal Reserve responded to the crisis by decreasing the effective federal funds rate from 5.25% in mid 2007 to around 3% in early 2008 to close to zero after the Lehman panic, where it remains to this day. It also lent to banks prodigiously via its discount window. When that proved inadequate to meet a variety of demands for cheap loans, it created seven new lending "facilities" designed to ensure the proper functioning of various credit markets. The Term Auction Facility auctions funds to depository institutions, the Primary Dealer Credit Facility provides overnight loans to dealers, the Term Securities Lending Facility promotes liquidity in the markets for Treasury bonds and other assets typically used as collateral for loans, the Asset-Backed Commercial Paper Money Market Mutual Fund Facility helps banks to purchase high-quality commercial paper from money market funds, the Commercial Paper Funding Facility backstops commercial paper issuers, the Money Market Investor Funding Facility provides liquidity to U.S. money market investors, and the Term Asset-Backed Securities Loan Facility supports the issuance of asset-backed securities collateralized by loans to consumers and businesses.
To justify such massive intervention in the economy, the government raised the specters of rapid financial system meltdown, a massive and potentially sustained decline in economic output, and levels of unemployment not seen since the Great Depression. Only with hindsight can we judge the accuracy of the government’s claims and the efficacy of its responses. Already, however, the clearly ad hoc nature of its bailout attempts has created the impression that it was no more prepared for the financial crisis than it was for Hurricane Katrina in 2005. The $2.6 trillion expended on bailouts so far is a sunk cost, water under the proverbial bridge. The important policy question now is how to prevent a recurrence not just of financial crises but of potentially over-exuberant government attempts to rectify the ill e¤ects of any number of potential economic shocks.
POLICY IMPLICATIONS
In terms of future policy, the chapters in this volume collectively suggest the following course:
• Regulators should work much harder to identify and if possible prevent the formation of asset bubbles. That means reducing incentives for risk taking by properly pricing government insurance or other guarantees and reforming the tax system. It also means keeping a close watch on markets for assets that
– can be shorted or otherwise arbitraged only at great expense;
– can be purchased with cheap borrowed money;
– are subject to high agency costs, including poor corporate governance;
– have recently attracted numerous inexperienced participants; or
– are subject to higher levels of risk taking due to the moral hazard created by repeated recent bailouts.
• The Federal Reserve’s initial reaction to financial market stringency ought to utilize Hamilton nee Bagehot’s Rule rather than lower interest rates for the entire economy. At the same time, money supply growth must be maintained to prevent deflation, even if that means injecting newly created money directly into the economy.
• If a crisis deepens, the government should continue making short-term loans and expanding the money supply but also begin purchasing equity in solvent but stressed financial companies. Instead of an ad hoc process subject to the political process, fear mongering, and emergency conditions, a new or existing agency needs to be empowered to make the equity capital injections, subject of course to specific limits and oversight determined before the next crisis strikes.
• Implementation of either Hamilton’s Rule or equity injections should be coordinated internationally, lest MNEs subvert the bailout process by engaging in regulatory arbitrage.
• The government should not protect jobs with tari¤s or bailouts of non-financial companies. Rather, it ought to protect family income by offering ample unemployment insurance and other assistance to families that su¤er a decline in income through no fault of their own. As the economy improves, the assistance needs to be drawn down so as not to encourage Western European levels of structural unemployment. Again, such policies should be in place before a crisis occurs so they can be designed according to reason and not distorted by partisan politics or fear.
• Likewise, the government should make plans to provide educational and training assistance to workers permanently displaced by the structural economic changes that often occur after crises. Similar programs already in place have already proven woefully inadequate and will undoubtedly be inundated over the next few years.
It would be prudent to enact this course with all deliberate speed to prepare for the next crisis, which the current spate of bailouts may already be creating. Very low interest rates, fast money supply growth, and high levels of moral hazard suggest that a cauldron of inflation and excessive risk taking may be brewing again soon. The better prepared the government is, the less economically, politically, and socially disruptive the next crisis will be.
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