Bailouts Are Unavoidable, but Should Be Avoided

There's a cause all politicians claim to love: ending bailouts. A recent amendment by Barbara Boxer (D-CA) made this clear, passing 96-to-1. It sought to end bailouts, no matter what. Of course, as Michael Kinsley pointed out in a recent piece, short of a constitutional amendment, that's impossible. But should bailouts be avoided at all costs, as Congress appears to be calling for?

Brookings Institution economic policy scholars Martin Neil Baily and Douglas J. Elliott say no. In an article, they assert that "bailouts are necessary to avoid the risk of a depression." For that reason, they oppose any attempts to tie the government's hands with inflexible rules that would prevent Washington from saving the economy, if necessary. They go on to say that the tools need to be in place for the government to act quickly when bad things happen.

On one hand, they're right. Because it's impossible for us to ever predict precisely what the world will look like in the future, we can never be certain that a bailout won't be better than the alternative. As ugly as the bailouts of 2008 were, 25% unemployment would surely have been worse. So any move to completely eliminate the government's ability to perform bailouts is likely ill-advised.

On the other hand, you don't want to make the prospect of bailouts too easy. Firms need to fear bankruptcy. Just because bailout is possible doesn't meant that it should be expected. While the financial panic that gripped the markets in 2008 was awful, in a sense, it was also wonderful because it showed their fear of failure. Firms worked very hard to keep the economy afloat, never assuming a bailout would occur. This is made abundantly clear if you read accounts (like former Treasury Secretary Hank Paulson's "On the Brink") about the big banks working together to try to figure out a way to save some of the firms that were collapsing during the crisis, including Lehman Brothers and Merrill Lynch.

So the right government reaction is to criticize bailouts and make them very difficult. If they're too easy, then businesses will take too much risk. Congress should have to approve any major bailout initiative on a case-by-case basis, just like they did in 2008 for the bank bailout. That was a brutal time, and Congress wasn't thrilled, but ultimately they all put politics aside and did what needed to be done, no matter how bad it stunk. Its action wasn't lighting-fast, but its speed was sufficient to prevent a depression.

In the meantime, actions should also be taken in an effort to avoid future bailouts. That's part of what financial reform intends to do. Congress hopes a systemic risk regulator will help. A non-bank resolution authority couldn't hurt. But they aren't enough. Higher capital requirements and leverage limits could also bring greater stability, though the Senate's bill overlooks them.

What all Washington's reform lacks at this time is some effort to prevent financial panics. It wasn't really the mortgage-related losses that caused the financial crisis -- it was the uncertainty of financial market participants. Financial institutions and investors didn't know how big the losses of other firms would be, or the amount of capital cushion they had in place. Was there hidden leverage that would magnify losses? The complexity of securities made it even harder to figure out what a firm's assets were worth.

So many financial institutions were on the verge of failure because they couldn't turn over their debt. They weren't only highly leveraged, but much of their debt was short-term -- and it was coming due faster than they could secure new funding to roll it over. Why hasn't anyone talked, not only about leverage limits, but about leverage maturity concentration limits? It might be fine to be leveraged 15-to-1, but not if 90% of that debt has to be refreshed each week.

Transparency is also important, and somewhat taken up by the bills being considered by Congress. But they should be doing more to create an environment where, even in a financial panic, firms have time and disclosure in place to easily present clear and convincing evidence that there's no reason for financial institutions and investors to fear the worst. The fundamentals at very few big financial firms should have actually caused failure during the 2008 crisis based on losses alone, but all were on the verge of collapse due to widespread uncertainty that caused liquidity to dry up.

If you want to avoid bailouts -- and it seems just about everybody does -- then you need to reform the cause and prevent panics from becoming severe. Just watching the financial system more closely in the hopes that you can spot a problem before it results in a catastrophic event isn't enough.