Best Practices for Bailouts

WASHINGTON, OCTOBER 10, 2008--"Bailout" has become a word on everyone's lips. "Over the past several months, we've had a lot of practice in bailouts, but it isn't clear that we have a theory to govern all this practice," Alex J. Pollock said at an AEI conference on October 8 at which financial policy experts convened to assess the efficacy of the government's current $700 billion bailout plan.

Bailouts occur, Pollock explained, because governments want to provide citizens with risk-free deposits. However, these deposits are used to "fund a business which is quite risky and highly leveraged--namely, banking. If you think about it, it's manifestly impossible to have risk-free funding of something which itself is quite risky. That's a contradiction in terms."

Adam Lerrick of AEI and Carnegie Mellon University added that "people have to realize that crises are a fact of a capitalist economy. . . . Capitalism without losses is like religion without sin. It doesn't work." AEI's Vincent R. Reinhart agreed, citing time-tested characteristics of financial crises: they happen repeatedly without regard to national boundaries, and they tend not to be short or cheap.

Though bailouts have an immediate, beneficial impact on financial markets in crisis, they may have adverse long-term implications because they distort the market's incentive structure. Lerrick argued that bailouts teach the market that it can afford to make risky bets without having to fear significant losses. In essence, this "turns the financial markets into a casino . . . where the house rule is very simple: when you win, you win, and when you lose, you don't pay." However, he recognized that bailouts are as inevitable as crises in a democratic society. "A bailout is always the best [political] solution because the bailout makes the problem go away. Everyone's happy--the losses disappear magically onto the balance sheet of taxpayers, and markets return to functioning normally."

The Federal Housing Finance Board's Allan Mendelowitz, who was deeply involved in negotiating the Chrysler Corporation's loan guarantee in 1979, argued that thoughtful, well-structured bailouts can be both successful and beneficial. He outlined seven key principles that are necessary for effective and responsible government intervention:

• Establish a clear public policy objective and design the program to achieve this objective.
• Vest decision-making authority in a strong and independent board.
• Use government funds solely to achieve the clear public policy objective.
• Use government resources sparingly.
• Commit to a reasonable plan for repayment of government funds.
• Limit the program's timeframe and scope.
• Ensure that the government shares in the upside of success.

Other panelists suggested additional attributes of a successful bailout plan. Desmond Lachman of AEI emphasized that the cause of the financial crisis must be correctly diagnosed; the bailout must address banks' solvency problems by supplying the banks with additional capital. Lerrick differed on the root cause of the current financial panic, identifying it as "an information crisis [because] lenders have plenty of funds but are hoarding their cash because they cannot distinguish the weak from the sound borrowers." He suggested that the crisis will not be resolved until adequate disclosure is available to identify the health of financial firms. However, both Lerrick and Lachman agreed, in Lachman's words, that "time is of the essence. The longer it takes for us to do the necessary bailout, the deeper the recession is going to be."

When evaluating the administration's current bailout plan, the panelists were unanimously underwhelmed. Mendelowitz noted that the proposal failed even his first standard of successful bailouts, lacking a "credible policy framework" as well as any semblance of "accountability, oversight, risk of legal review, or conditionality." Lachman had hoped that the bailout would be part of a larger plan to address the problems in the financial system and was disappointed that the government seemed to lack "any strategy in terms of how to bail out the entire financial system." In evaluating the current bailout, Reinhart referenced his three rules for bailouts. "One, don't do them; two, if you break rule one, at least make sure that government policy is consistent for all institutions; and three, if you break rule two, it will be expensive." He noted that the U.S. government quickly advanced to the third rule after its unequal treatment of Bear Stearns and Lehman Brothers, and he worried this was a bad omen for the duration and severity of crisis recovery.

Only Pollock left the audience with encouraging words. "The bust doesn't last forever--we always get to the other side."

--KAREN DUBAS

For more AEI scholars' research on the financial crisis, visit www.aei.org/FinancialCrisis/.

For media inquiries, contact Veronique Rodman at 202.862.4870 or vrodman@aei.org

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