As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many developing countries have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalization and deregulation have, in most cases, more than offset the output and bailout costs of crises. Importantly, financial liberalization by itself did not generate crises—government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not so different.
In the debate, pundits are railing against the enormity and unfairness of the US bailout, not to mention the bad precedent it will set. Many also point to deregulation as a key cause of the crisis. The facts suggest otherwise.
First, the size of the bailout is within historical and international norms. Second, financial liberalization and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relative to EU countries. The development of new financial instruments has helped finance the information technology (IT) revolution and the large-scale increase in home ownership. Both factors have been powerful engines of US growth. Third, policy interventions, such as the effort by some in the administration and Congress to induce Fannie Mae and Freddie Mac to move into the subprime mortgage market, have largely paved the road to the financial crisis.
Illustration: Jayachandran / Mint
How big is the current US bailout? The $700 billion bailout bill is equivalent to 5% of gross domestic product (GDP). Adding to it the cost of other rescues—Bear Stearns Companies Inc., Freddie Mac and Fannie Mae, AIG—the total cost could go up to $1,400 billion, which is around 10% of GDP. In contrast, Mexico incurred bailout costs of 18% of GDP following the 1994 Tequila crisis. In the aftermath of the 1997-98 Asian crisis, the bailout price tag was 18% of the GDP in Thailand and a whopping 27% in South Korea. Somewhat lower costs, although of the same order of magnitude, were incurred by Scandinavian countries in the banking crises of the late 1980s—11% in Finland (1991), 8% in Norway (1987), and 4% in Sweden (1990). Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of GDP.
The bailout costs that taxpayers are facing today can be seen as an ex-post payback for years of easy access to finance in the US economy. The implicit bailout guarantees against systemic crises have supported a high growth path, a risky one, for the economy. In effect, the guarantees act as an investment subsidy that lead investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors—such as housing, small businesses, Internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government would make sure they get repaid (at least partially).
Importantly, there must be systemic insolvency risk for the bailout scheme to have these effects. This is because a bailout is not granted if an isolated default occurs, but only if a systemic crisis hits, since only under the threat of generalized bankruptcies and a financial meltdown would Congress agree on a bailout. Thus, an investor would be willing to take on insolvency risk only if many others did the same. When a majority of investors load on insolvency risk, they feel safe (because of the bailout guarantee). No wonder many financial firms end up with huge leverage and loaded with risky assets. In the Tequila and Asian crises, the risky bet was the so-called currency mismatch, in which banks funded themselves in dollars and lent in domestic currency. In the US, it took the form of toxic mortgage-related assets. There are no innocent souls here. Borrowers, intermediaries, investors and regulators understood the bargain.
Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today and the IT sector in the late 1990s. But the bottom line remains that risk-taking has positive consequences in the long run even if it implies that crises will happen from time to time. Over history, the countries that have experienced (rare) crises are the ones that have grown the fastest. In those countries, investors and businesses take on more risks and as a result, have greater investment and growth. Compare Thailand’s high-but-jumpy growth path with India’s slow-but-steady growth path before it implemented liberalization a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.
Published with permission from VoxEU.org. Romain Rancière is an associate professor of economics at Paris School of Economics and a CEPR research affiliate. Aaron Tornell is a professor of economics at the University of California, Los Angeles. Frank Westermann is a professor of international economic policy at the Institute of Empirical Economic Research, University Osnabrueck. Comments are welcome at firstname.lastname@example.org