Friday, February 20, 2009

Hazardous Bailouts

Normally, in a capitalist society when companies make good decisions, their investors profit, and when they make bad decisions, their investors suffer. Investors have an incentive to be careful with their money and to not finance foolish or reckless ideas. In bailing out the financial industry the government is threatening to create moral hazard by reducing or eliminating the potential downsides for making poor choices. Not only is a “Heads you win, tails we lose” solution to the current crisis grossly unfair to the American taxpayer, it encourages repeat offenses.

For many economists and politicians considering various bailout plans, moral hazard has become a secondary issue. They argue we can’t worry about long-term problems when the whole system is about to implode. While I tend to subscribe to that philosophy in my own personal life, there is a very important group of people to whom the issue is an immediate concern: potential investors and creditors. As long as there is a great deal of uncertainty about what the government intends to do, potential investors and lenders are going to be wary of sinking money into the financial system. No one wants to get in if there’s a good chance the government will nationalize.

If the government intends to give existing shareholders and unsecured creditors a “haircut” or wipe them out, now’s the time to do it. If it intends to just throw money at the banks without a meaningful downside, it needs to make that clear. Also any Congressman who votes for that particular bailout might also want to take the opportunity to announce that he will not be running for re-election in 2010. Given the popular anger directed at Wall Street at the moment, a pledge not to nationalize or impose stiff restrictions may not even be credible. Ultimately, the solution doesn’t just need to be able to fix the credit crunch; it also needs to be politically viable.

Willem Buiter offers an interesting “Good Bank” solution that includes a certain degree of nationalization. The government (possibly together with some private capital) would set up a “good bank” for every insolvent bank. It would transfer the bulk of the employees to the “good bank,” purchase all the assets that can be priced in the market on its behalf, then withdraw the banking license of the old bank. This would leave the old bank, with its old shareholders and creditors and bad assets, while the new bank is healthy and ready to operate like a normal bank. If the toxic assets of the bad bank turn out to be worth something in a few years when the economy has sorted itself out, the old bank’s creditors and shareholders regain some of their money, if not, that means the bank was worthless anyway; meanwhile, the new bank, unfettered by unnecessary restrictions or bad debts goes about its business, and is eventually privatized, helping taxpayers recoup their investment. This gets credit flowing immediately and leaves the messy attempts to price illiquid assets for later when there is no time pressure.

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