Government Bailout

4. Should governments use public money to bail out failing institutions?

4.1 Introduction

The great recession in the U.S. economy began at the end of 2007 aroused concerns all over the world as an epic financial crisis that shattered business and consumer confidence. By the second half of 2008, the United States was deep in the worst recession since the 1930s, and major financial institutions were faced with bankruptcy. A risk that the global financial system might collapse emerged, implying that it was a repetition of the lengthy economic devastation of the Great Depression of the 1930s.

In order to stabilize the situation, governments reacted by creating huge stimulus packages to bailout the failing institutions, which meant private losses were being funded by public money. Under such severe circumstances during the global financial crises, the bailout packages may have been necessary to save the financial system. However, the issue of giving public money to the shareholders as well as management of institutions to cover their mistakes has been a global conundrum for decades. On the one hand, analysts have always felt that the nation could not do otherwise than provide bailouts; on the other hand, the bailout packages would greatly increase national deficits and debts, simultaneously, creating moral hazards.

4.2 Pros for government bailouts

After the outbreak of the financial crisis, in order to ease the credit crunch, avoid the financial and economic system destroyed by the collapse of large institutions, the Fed and the Treasury were forced to implement public intervention of an unprecedented scale. They took unconventional mode to rescue the market several times, even at the cost of violating their persistent principle of taking policies that were beneficial to specific companies or markets. Therefore, there must be a justification that urged the government to bail out those failing institutions by such unconventional measures.

One of the main purposes of the bailout policies is to relieve the market panic caused by the escalation of the subprime crisis. An important index to evaluate the America financial market sentiment is a change in the VIX index (Volatility Index), which is recognized by the market as the ‘investor sentiment index’.

Before the escalation of the subprime crisis, although the VIX index kept rising, it was still below 30. However, after the Fed and the Treasury gave up the Lehman Brothers as an ‘tradeoff’, VIX index rose from 25.66 to 31.70 and market appeared signs of panic. Then, when the House of Representatives denied the 700 billion bailout bill, the VIX index soared further. Nevertheless, after the House of Representatives passed the revised 700 billion act and cut the interest rate twice, the VIX index declined finally. (China Economic Report 2009)^[1]

Therefore, government bailout is an effective way to ease public’s panic and enhance their confidence towards market.

4.3 Cons for government bailouts

When dealing with systematic financial crisis, government’s timely rescue will be of great significance to those failing institutions, or else it will be too costly to let them bankrupt. However, under the rescue of government, moral hazard will also appear.

The core idea of the new version of the Basel Capital Accord (Basel III) is to require financial institutions to further increase its capital to cover risk, improve capital quality and enhance the ability to resist risks, which is in accordance with the efforts that government needs to reduce the moral hazard after financial bailout. Government should try to strike a balance between bailing out failing institutions and dealing with the potential moral hazard. Since some institutions have double protection, if the supervision of the member bank gets relaxed, the protection from the Federal Reserve System acted as the ‘lender of last resort’ still remains, these financial institutions and organizations will not conduct their operation sanely and carefully. In the common moral hazard models, although the book deficits of government before the crisis is not big, because the government is the final undertaker of the enterprise investment loss, large potential fiscal deficit exists and they will be digested through monetization, while the expectation of deficit monetization will bring forward the arrival of crisis. (Minsky 1986)