No More Bailouts

Tuesday, March 01, 2011 » posts.tags:

“The tax payer has been funding the banks more than enough! No more money for banks! Make the rich pay!” It’s en euphemism to state that similar points of view are the common denominator in the press that reports on the dramas since the Global Meltdown in 2008.
There are a few problems with these popular statements though. There is a misconception and there is a complicated truth about complex, interdependent economic dynamics.

First, the simple misconception.

After a month of intensive reporting about the bailout in Ireland, I read in a newspaper “How could Lenihan [finance minister and official laughing stock of Ireland] take money from the Pension Reserve Fund? No money can be withdrawn now”. When reading the press reporting about the media about the “bailouts”, it is easy to understand where this misconception comes from. Media reported about the bailouts as if it was a donation (and continue to do so). In reality the bailouts are loans and/or share purchases.
Loans that have to be paid back or shares that can be sold later.
The Troubled Assets Relief Program (TARP - that was installed in the USA in October 2008 for example has for 2/3rd been paid back and on those assets paid back there is a 15% profit for the taxpayer (or almost 10% profit on the whole portfolio; while still about 100 billion has to be paid back). This is to date a profit of almost 30 billion USD for the USA taxpayer.
Of course the outstanding 100 bln is still at risk (if it will be paid back there is more profit, but the involved companies can still go bust and not pay back).

Second, the complex economic dynamics.

This subject is so complicated that I hardly can blame the press to do an effort to explain this. True, it is more the subject for a PhD than a one-pager blog, but if one sticks to the basics it is not too complicated.
First we have to distinguish the bailouts for countries and those for specific companies (such as banks).
A bank operates to some extend similar to a hedge fund in that sense that it leverages many times its assets and by that leveraging it creates cash that is used by other industries. This is essential for economic growth. In the wake of 2008 we have seen that the major problem for everyone was to get loans (because the banks had problems). This has lead to economic depression (except for Poland that is) and made other markets tumble. We have to underline that in 2008 there was only one bank that went belly up, without the TARP it could have been much worse. The major problem of a bank going bankrupt is the domino effect that it creates: it will pull other banks down and all banks will have to be more restrictive and so they impede the economy.
The story for countries is also complex, but also here the alternative to a bailout is bankruptcy. When a country defaults on its debt it can as a sovereign choose how to get out of the situation. The biggest problem is to gain confidence of the investors in order to be able to emit new bonds. So the state will typically devaluate its currency and then pay back a part of the value of the bonds in that devaluated currency (for example pay only the face value and no interest). The years to follow the state will pay very high interest rates because of the weakened confidence, the interest rates in the country will be high (impeding the economic growth), inflation will be high, etc.
The main problem is that after a default a state will not have easy access to funding. It will have to cut on many expenses, probably more so than in a bailout scenario! So people that are protesting against the bailouts should realize that the alternatives are not necessarily better. Indeed the cost cuttings that accompany a bailout (because remember, it’s no charity it’s a loan that has to be paid back – so the ones that provide the money (not “give”) want the country to improve its finances in order to be able to pay back the investors)

By allowing one country to default on its debt, Europe creates a precedent and as that will trigger a loss of confidence in Europe, the cost of funding will dramatically increase for every taxpayer in Europe.

All that is true, but it does not exclude that a bailout is socially a reasonable solution. The alternatives are also harsh for all layers of the society.
The only good solution for the future is to avoid such situations. This is not something that a invisible hand can do: real regulation of the banking system (that goes beyond demagogic rhetoric) is a first step. Guidelines of tax structuring, leveraging, balance, debt ratios, debt structuring, debt currency, with real risk parameters such as CVaR to be used (not flawed –but popular– measures such as volatility or VaR!