Do banking-system bailouts work? Yes. But some work better than others. They’re also mind-bogglingly expensive.
Unfortunately the current Hanke-Panke Plan shares a few attributes with the bailouts that didn’t work so well…and its price tag is likely being vastly understated. This is why we expect Paulson (or his successor) will soon be back on Capitol Hill with a new plan, begging Congress for more money.
Analyst John Mauldin’s Outside The Box email this week features a summary of the Luc Laevan and Fabian Valencia study of 42 recent bailouts. John excerpts the work of Philippa Dunne and Doug Henwood of The Liscio Report, who analyse the study in detail. Here are the key points:
- Taxpayers are already on the hook for all those crap loans regardless of what we do. The only question is whether we pay for them via a bailout or a second Great Depression. The average bank bailout costs 13% of GDP, net of any eventual asset recoveries. This would be just under $2 trillion in the US…more than double the “$700 billion” Paulson plan.
- Speed matters. The speed with which the government acts is critical. Hank Paulson and Ben Bernanke have so far acted very quickly. It took Japan more than five years to do what the U.S. has already done.
- Denial doesn’t help–so don’t eliminate mark-to-market. Many pundits have seized on mark-to-market accounting as one cause of our problem, and they appear to have persuaded the SEC to reduce the use of it. The way to get out of a banking crisis is to take the full hit, recapitalize the banks, and then move on. Eliminating mark-to-market, therefore, is unlikely to help (and might actually hurt).
- Bank restructuring is necessary, but the core tenet of the Bernanke-Paulson Plan–crap asset purchases–is not the best way to go. Instead, the plan should recapitalize the banks with equity. Ever since Hank and Ben announced their bailout plan, we and others have been mystified as to why they want to buy bad assets instead of inject new equity into the banks. Here’s how Dunne and Henwood put it: Some sort of systemic restructuring is a key component of almost every banking crisis, meaning forced closures, mergers, and nationalizations. Shareholders frequently lose money in systemic restructuring, often lots of it, and are even forced to inject fresh capital. The creation of asset management companies to handle distressed assets is a frequent feature of restructurings, but they do not appear to be terribly successful. More successful are recapitalizations using public money (which can often be partly or even fully recouped through privatization after the crisis passes); recaps seem to result in smaller hits to GDP. But they’re not cheap: they average 6% of GDP, which for the U.S. would be about $850 billion.
- Some sort of systemic restructuring is a key component of almost every banking crisis, meaning forced closures, mergers, and nationalizations. Shareholders frequently lose money in systemic restructuring, often lots of it, and are even forced to inject fresh capital. The creation of asset management companies to handle distressed assets is a frequent feature of restructurings, but they do not appear to be terribly successful. More successful are recapitalizations using public money (which can often be partly or even fully recouped through privatization after the crisis passes); recaps seem to result in smaller hits to GDP. But they’re not cheap: they average 6% of GDP, which for the U.S. would be about $850 billion.
- Successful plans have included debt relief for strapped consumers and businesses, which the Paulson plan currently doesn’t.
What can we learn from this? Several things:
- Paulson and Bernanke should use the bailout money to recapitalize the banks, not buy bad assets. They should also be selective: Focusing on the strongest banks and letting the weaker ones fail. The plan should also include more relief for homeowners.
- This crisis is going to cost a boatload of money regardless of what we do: It it’s an average bailout, it will end up costing something on the order of $2 Trillion. We’ll also likely have a severe recession even if the bailout is a home run.
- As Paulson has said, taxpayers will be paying for this mess regardless. The only question is whether we want to pay for it with fiscal spending (the Paulson plan) or lost revenue (a second Great Depression).
On a positive note: Bailouts work. Contrary to some concerns, they also don’t necessarily trigger Zimbabwean-like inflation or 1929-like stock market crashes. In three of four major developed world crises–Norway, Sweden, and Korea–three years after the bailout, stock markets were higher and inflation lower. (Alas, this was not the case in Japan). Dunne and Henwood:
Most of the countries in the Laevan/Valencia database are in the developing world, and are of questionable relevance to the U.S. But TLR has taken a closer look at four countries that offer more relevant models: Japan, Korea, Norway, and Sweden…
Sweden, now widely seen as a model of swift, bold action, kept its ultimate fiscal costs relatively low –3.6% of GDP at first, almost all of which was recovered through stock and asset sales– but was unable to avoid a deep recession. [Sweden recapitalized its banks. It didn’t launch a crap-asset purchase plan.] At the other end of the spectrum, Japan, the model of foot-dragging half-measures, saved no money through its procrastination; its fiscal outlay was 24% of GDP, almost none of which was recovered. And it was unable to avoid recession.
Note, though, that some of the worried talk surrounding the financial market impact of bank bailouts looks misplaced, at least on these models. Three years after the outbreak of crisis, inflation was lower and stock prices higher in all four countries, and government bond yields were lower in all but Japan. It’s likely that the deflationary effects of a credit crunch outweigh the inflationary effects of debt finance.
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