This article first appeared in the St. Louis Beacon: November 18, 2008 - In the past few months, the government has intervened in the market at an unprecedented level, putting cash into financial service firms by direct loans or purchase of their preferred stock. And more is promised.
Why? (1) Serious economic trouble first surfaced in the financial services industry, with JP Morgan Chase rescuing Bear Stearns and Lehman Brothers failing. (2) The belief exists that any failure of a financial institution has significant "multiplier" effects on "main street."
As an example of the second point, consider that, just by the end of the first quarter of 2008, the credit crunch had wiped out nearly 6 quarters of the profits of the financial services industry, and estimates are that earnings lost (measured in terms of precrisis earnings) could reach 2.53 years worth by the end of the crisis.
But here is the real rub: If U.S. financial institutions were to end up losing $200 billion, credit to households and companies would contract by $910 billion, a 1.3 percent drop in real GDP growth rate the following year!
And since July of this year, the crisis has deepened and spread more widely. Plus, a constant stream of bad economic news seems to keep appearing, which saps confidence.
To deal with this worsening crisis, the government has been involved in rescue efforts that have included investment banks, large commercial banks, small commercial banks, insurance companies (notably AIG), mutual funds and others. Now the automobile industry wants a bailout.
Are such bailouts good or bad for our economy?
The argument for bailouts goes as follows.
If we allow large firms, especially financial service firms, to fail in a free-market system, they may take other firms down with them, causing economy-wide harm through a contagion effect. This happened during the Great Depression as runs on some banks precipitated panic runs on other (otherwise healthy) banks and bringing the system to a grinding halt. Regulators responded in the 1930s by creating federal deposit insurance.
Some claim that the government's decision to allow Lehman Brothers to fail - and the losses that implied for money-market funds holding its debt - led to a global run on wholesale credit markets. That is precisely the argument Detroit is now making for a bailout of the auto industry. Economists refer to this as an ex post efficiency case for intervention - now that we are in this mess, let's intervene, restore confidence and keep it from getting worse.
Countering this argument is the ex ante efficiency case against government intervention.
It says that free markets work precisely because they reward success (by allowing high profits to be earned) and punish failure (by forcing the exit of firms that made poor decisions). Individuals and firms take prudent risks in the hope of generating wealth. But they shy away from excessive risk because they can go broke. This balance provides the right incentives in the end.
If the government takes away the "cost" of failure, it also robs the system of its natural discipline, leading to an economy in which "profits are privatized and losses are socialized."
Let's say you go to Vegas and the casino lets you keep your winnings but insures you against your losses. How would you behave? So, too, the government's intervention may do some good today, but it sows the seeds for the next crisis by creating perverse incentives for tomorrow.
In a paper I published in 1985 in the Journal of Public Economics with Paul Chaney ("Incentive Effects of Benevolent Intervention: The Case of Government Loan Guarantees"), I showed that government loan guarantees given to firms today can create incentives for excessive leveraging of firms in the future. This is exactly the opposite of what we need today, as excessive leveraging at the individual and corporate levels is a root cause of this crisis.
How then do we know when we should applaud government bailouts and when we should not?
First, keep in mind that a government bailout is primarily intended to stave off bankruptcy; it cannot fix a broken business model. So, we need to understand that a company in financial distress has two choices: to go for reorganization under Chapter 11 of the bankruptcy code or liquidation under Chapter 7.
Under Chapter 11, the firm does not cease to exist. As it continues to operate, bankruptcy proceedings allow the firm to restructure its balance sheet, renegotiate terms with its creditors, tear up its contracts with employees, dealers and others, and start afresh. Creditors' claims are essentially frozen to give the firm "breathing room." Bankruptcy has often been used strategically for renegotiating contracts, restructuring and allowing the company to emerge from bankruptcy proceedings a healthier organization.
We have all flown airlines while they were going through bankruptcy, which allowed the airlines to restructure contracts, including those with labor, and emerge financially stronger. By contrast, with Chapter 7 the firm's assets are liquidated to pay off creditors and other claimants, and it ceases to exist. With both Chapters 7 and 11, shareholders' claims become worthless.
The issue of whether the government should bail out a company to forestall Chapter 11 really boils down to whether it is in the best interest of the economy to have the firm tear up its contracts with its employees, dealers, creditors and others.
If the costs of the bailout exceed the benefits of avoiding bankruptcy and thus not tearing up contracts, the government should not intervene and should allow the company to go into Chapter 11.
But if the anticipated benefits of forestalling the invalidation of existing contracts exceed the costs of the bailout, government intervention to forestall Chapter 11 may be warranted.
One could argue that the "lifeline" loans to and preferred stock purchases in AIG and other financial institutions were justified because these institutions are counterparties in numerous transactions. If the government allows Bear Stearns to enter Chapter 11 and this invalidates its swap contracts, the whole financial system could have a huge problem because Bear Stearns was a counterparty in $10 trillion of swap contacts. Who replaces Bear Stearns as the counterparty? What if a replacement cannot be found?
How many institutions would be forced to sell assets to cope with the consequences of the loss of a counterparty? Similar concerns also existed with the insurance giant, AIG. In other words, the government intervened because the invalidation of contracts in Chapter 11 may have proved to be unacceptably costly for the economy.
What about the automobile companies?
Here the argument changes. The biggest problems the Big Three face are
- They have products not enough people want to buy;
- Their "legacy costs" - the costs of pensions, employee benefits and so on - are so high that their cost structure is not competitive;
- There are far too many dealerships compared to their German and Japanese competitors.
Entering Chapter 11 would actually be beneficial to these companies because it would allow them to restructure and renegotiate all of their economically inefficient contracts, including those with the labor unions and dealers. The companies would emerge from Chapter 11 as stronger and more viable organizations. A government bailout to forestall Chapter 11 would not only be costly to taxpayers but would also put off the contract renegotiations that these companies so desperately need.
It is like well-meaning parents giving their child a painkiller to postpone the very surgery that would save the child's life.
Anjan Thakor is John E. Simon professor of finance and senior associate dean at the Olin School of Business, Washington University.