An international perspective on the US bailout

The current credit crisis in the US has prompted many calls for some form of regulation to prevent such an event from ever happening again. In a new column at VoxEU.org Romain Rancière, Aaron Tornell and Frank Westermann defend a financial system that engenders systemic risk. Economies that risk occasional credit crises enjoy higher long-run growth, and the cost of the US bailout is well within historical norms. Not your standard view of the situation.

The column, An international perspective on the US bailout, opens by noting

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 liberalisation and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalisation 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.

Rancière, Tornell and Westermann go on to point out that many commentators point to financial deregulation as a key cause of the crisis. In Rancière, Tornell and Westermann's view the facts suggest otherwise.

• First, the size of the bailout is within historical and international norms.
• Second, financial liberalisation and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relatively to EU countries. The development of new financial instruments has helped finance the 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 the US faces today.

One question to ask is How big is the bailout compared to others? Rancière, Tornell and Westermann note

The $700 billion bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues – Bear Stearns, Freddie Mac and Fannie Mae, AIG – the total bailout costs could go up to $1,400 billion, which is around 10% of GDP.

But they put this into perspective by pointing out that

• 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 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.

They also explain the costs of the bailout that taxpayers are now facing 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 for the economy – albeit a risky one. In effect, the guarantees act as an investment subsidy that leads 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 will make sure they get repaid (at least partially).

Such effects from a bailout scheme only occur when there is a systemic insolvency risk. This is simply because a bailout is not forthcoming if an isolated default occurs, it will only be granted when a systemic crisis hits because it is only under the threat of generalised bankruptcies and a financial meltdown that would the US Congress would agree to a bailout plan.

Thus, an investor will be willing to take on insolvency risk only if many others do 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. At the end, the bailout guarantee scheme has succeeded in inducing more investment by financially constrained agents in real estate and small businesses.

Now what of the positive side of risk-taking in the long run. Rancière, Tornell and Westermann say

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 liberalisation 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.

Many people are arguing for a rolling back of financial liberalisation and for a return of the "good old days" of strict regulation. But if Rancière, Tornell and Westermann are right then maybe this is not the right response to the current situation.

Rancière, Tornell and Westermann conclude

Today's bailout price seems high. But is it that much relative to the higher growth the US has enjoyed in specific sectors and overall? Let's wait for the final price tag. Other countries' experiences tell us that financial liberalisation – and some of its consequences – is not such a bad idea after all. They also teach us the importance of quickly jump-starting the lending engine so as to avoid a growth collapse and for the regulatory agencies to refrain from killing the natural risk-taking process that accompanies the resumption of credit growth.