The Lehman Brothers story has shown two things – banks cannot be simply allowed to go bankrupt and a piecemeal approach will not bring banking systems back into minimal functioning condition. The lesson is that there will have to be a bailout. The contagion from the US to Europe and now to most other parts of the world further shows that the bailout will have to be global. The question is how to do it and who will bear the cost.
Four measures are jointly necessary to clean up the financial mess:
- Absorb significant amounts of toxic assets (and each day’s fall in stock prices widens the definition of toxicity);
- Recapitalise banks;
- Restart the interbank market;
- Prevent bank runs by guaranteeing all deposits.
There are many ways of proceeding with each measure. For example, debt-for-equity swaps can achieve the third and fourth measures. Effectiveness is a key consideration, of course, but it is not the only one. The cost of the bailout, likely to amount to many percentage points of GDP, matters greatly. Nor can we ignore the moral hazard component since it matters greatly for the future and, more ominously perhaps, since the long-run political implications of the crisis will be deep.
The Paulson plan deals with the first measure. The British plan deals with the second and third measures. Decisions taken in Ireland, Germany, Greece and Austria deal with the fourth. Most European countries seem to be determined to operate on a case-by-case basis. A comprehensive plan remains to be adopted anywhere in the world.
An essential ingredient is that taxpayers get a fair share of the upside. The British plan achieves this but in a modest way, as preferential shares limit both the up and the down sides. The Paulson plan is likely to take off only if the toxic assets are bought above current market value, which limits the upside and increases the downside. European-style case-by-case bailouts mostly involve regular shareholding, with significant up and down sides.
One reason why governments adopt partial measures is that they fear their costs. This is a mistake. The cost of the sum of the four measures is most likely to be significantly lower than the sum of each measure’s potential cost. Importantly, a comprehensive plan that includes all four measures raises the probability of success and therefore the odds that the upside will materialise. Thus, a comprehensive plan should encourage governments to emphasise measures that increase the upside.
It is very unlikely that one country will be able to salvage its banking system if others fail. Indeed, if some significant countries fail to respond adequately, the crisis may well worsen and, at the very least, raise the cost of the bailout for those countries that got it right.
Banks, which have been so good at regulation arbitrage, will indulge enthusiastically in bailout arbitrage, further increasing the costs. This means that comprehensiveness is not enough. All countries with systemically important banks need to closely coordinate as central banks have done so far. They do not need to adopt exactly the same plan, but plans that correctly include all four measures.
In addition, as the world tips into a global recession, macroeconomic policies are urgently needed to dispel the risk of depression. Central banks have been extraordinarily active in providing liquidity. They must shift to also supporting the economy. Fiscal policy too must contribute. It may be difficult to contemplate larger deficits at a time when huge fiscal commitments must be made. Again, a prolonged recession would cost considerably more than a shorter one.