The most pernicious idea haunting our financial sector bailouts is the idea that government guarantees are basically free of cost. The idea that a credible guarantee will rarely be invoked has been so completely contradicted by recent events that it is surprising to find anyone still holding on to the idea.
Some people, however, continue to insist that if you carry a bazooka in your pocket, you won’t have to fire it. And a recent blog post over at The Economist’s Free Exchange demonstrates that the Cult of the Guarantee is still alive and well even in otherwise respectable quarters.
What about all those other guarantees offered by the government which have encouraged people to continue doing business with Goldman Sachs and the entire financial system as a whole? Those are worth trillions of dollars, aren’t they? And the banks are using them to book billions in profits.
First, a guarantee only costs if it’s invoked, and it’s rarely invoked because it’s a credible guarantee. If we just totted up the potential cost of federal deposit insurance it would be enormous, but of course the very existence of deposit insurance eliminates the threat of bank runs, meaning that it’s only needed in cases of insolvency, which are generally rare.
Far from being costless, government guarantees have been extremely costly. The implicit guarantee of Fannie Mae and Freddie Mac comes to mind. The government’s explicit guarantee of Citigroup’s portfolio will also prove costly.
The fact is that government guarantees often have to be paid out, and governments typically under-estimate the costs. One reason that market so frequently calls on the guarantee is that the presence of the guarantee alters the behaviour of everyone involved, typically in the direction of irresponsibility.
Government budget accounting typically makes guarantees more attractive than they otherwise would be. Other forms of spending are far more subject to budgetary and political scrutiny. Guarantees can be presented as costing nothing, or costing no more than the current year’s estimated expenditures. Because the costs come in the future, politicians can hope that the time gap between enacting the guarantee and paying out on it will create room to escape culpability for the consequences.
Guarantees operate as budgetary time bombs. The eventual explosions are made all the worse by the refusal of politicians to discuss how they will meet the government’s obligations when the guarantee is called. Journalists make the problem worse when they confuse public expectations about the costs of the guarantees, so that the public is continually suprised that this thing is so expensive.
Unfortunately, calculating the expected costs of the guarantees is very difficult, if not impossible. One method is to use the cost of credit default swaps to calculate the implied probability of default. Right now, for Goldman, the market is not calculating that this probability is zero. It still costs something to insure Goldman’s debt. But it probably costs too little, since the CDS market itself is pricing in the guarantee.
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