A crises bailout primer

A crises bailout primer
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First Published: Tue, Sep 23 2008. 10 10 PM IST
Updated: Tue, Sep 23 2008. 10 10 PM IST
Every financial crisis leads to gallows humour — but the real joke is usually on the taxpayer who has to fund the subsequent bailout.
It’s no different this time around in the US. The Bush administration has finally abandoned its one-bailout-at-a-time strategy. It now proposes to buy out all the toxic debt that is choking the US financial system — cash for trash, as some acerbic critics have called it. There are too many unknowns in the plan. For example, it is still not clear how all those illiquid derivatives that are sitting in the books of Wall Street banks will be valued. Value them too low and the whole exercise becomes a pointless one, since very little money will reach the distressed banks. Value them too high and the bailout bill will be far higher than the current estimate of $700 billion.
The inconvenient truth is that though the risk of moral hazard is well understood, grand bank bailouts have been very common in recent years. What follows is a very, very short history of bank bailouts over the past two decades.
1. The US. The current US president’s father created a special purpose vehicle in 1989 to buy out the failed loans that destroyed 1,400 savings and loans companies. The total bill was $180 billion, or about 3% of US annual output at the time.
2. Sweden. A five-year boom in this Scandinavian country (between 1985 and 1990) ended in a spectacular bust. Bankruptcies threatened the entire financial system. The Swedish government created a $14 billion restructuring fund that bought out bad loans and nationalized some banks. The bailout cost was 4% of gross domestic product (GDP), which was recouped after the economy recovered and nationalized banks were relisted.
3. Japan. The pricking of the Japanese asset bubble in 1990 sent its banks deep into trouble. The world’s second largest economy has never recovered its lost glory since then, struggling with very low growth and deflation through most of this period. The initial $100 billion package in 1996 was followed by another one for $500 billion in 1998. Total cost: 12% of GDP.
4. East Asia: Another asset-cum-credit bubble, another economic collapse, another bank crisis. While there is no official consolidated estimate of the cost involved in getting regional banks out of the intensive care unit, most countries spent more than one-fifth of their respective GDPs to stem the crisis. Indonesia was the worst hit, with the Indonesian Bank Restructuring Agency trying to sell around $56 billion of bad debts (in today’s money) to investors. Ironically, a Wall Street investment bank called Lehman Brothers was adviser to the agency.
There are many other examples of systemic collapse — in Mexico, Turkey, Argentina — as well as large taxpayer-funded bailouts of individual banks, such as Credit Lyonnais in France.
Economists Carmen Reinhart and Kenneth Rogoff have shown in recent research that financial crises are a constant in economic life, though most crises are accompanied by impassioned arguments how “this time it is different”. They identify five cycles of financial crises over the past 700 years. Taking a more short-term view, the Reinhart and Rogoff analysis shows that the incidence of crises was low between 1960 and 1980 — and then shot up. The past few years, too, have been remarkably quiet on this front, till the current crisis blew up in the face of the financial system.
Just as financial crises are unchanging features of the economic landscape, so are taxpayer-funded bailouts. This creates a strong case to regulate the financial sector more tightly than it was over these past 20 years, though it is also worth remembering that the biggest problems in the US right now have emanated from tightly regulated financial institutions such as Fannie Mae and Freddie Mac rather than from lightly regulated hedge funds. This is a paradox that still needs a convincing explanation.
There are several lessons from recent bailouts, the most important being that the authorities have to move very fast. Japan was in a state of denial for almost five years after its bubble burst, which created problems that now seem intractable.
But there are two other lessons. First, most financial crises are followed by years of sub-par economic growth. Second, the final cost of bailouts averages around 13% of GDP, according to a 2002 World Bank study cited by MoneyWeek columnist Adrian Ash this May.
Three things follow from all this. One, the US government has — for all the ambiguities in the Paulson package — done well to move fast and prevent further financial deterioration. Two, the US economy is very likely to have at least a few years of anaemic growth or recession. Three, the current cost estimate for the bailout — $700 billion, or around 5% of US economic output — is most likely too low.
Your comments are welcome at cafeeconomics@livemint.com
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First Published: Tue, Sep 23 2008. 10 10 PM IST