Friday, June 28, 2013

Bailouts in History: A Common Solution?

Bailouts in History: A Common Solution?

By Robert E. Wright, Nef Family Chair of Political Economy, AugustanaCollege SD for the German Historical Institute, Washington, DC, 27 June 2013

[What follows is the substance of remarks I made at the GHI tonight. Unfortunately, the dozen or so excellent questions and remarks made by audience members in the q&a were not recorded and I can't do adequate justice to them from memory or my notes.]

A “bailout” -- a noun -- occurs whenever a government aids or “bails out” -- a verb -- a financially distressed business, industry, or another government. The noun and verb forms both evoke three emergency-related metaphors, emptying water from a sinking boat, parachuting from a doomed aircraft, and being allowed out of jail before trial. Bailouts are examples of a wider group of government resource transfers called subsidies or corporate welfare and should be differentiated from disaster relief, or aid designed to counteract distress caused by natural or manmade forces outside of the bailout recipient’s direct control and usual line of activity. Some bailouts entail no loss to creditors, employees, managers, owners, or other stakeholders while others protect only uninsured creditors or other preferred stakeholders. Some bailouts are systemic while others aid only specific entities.
Throughout the last few centuries, bailouts have taken numerous forms, including, but not limited to the following, in no particular order:
1.      asset purchases: where the government buys assets from troubled entities at above market prices;
2.      cash: where the government gives troubled entities money;
3.      contract flexibility: occurs when the government allows a troubled entity to receive full payment for late or substandard goods;
4.      criminal prosecution immunity: happens when the government does not prosecute individuals who have committed illegal acts in order to protect the troubled entities that employ them, as recently occurred in the HSBC terrorism case;
5.      subsidized insurance: is the practice of governments insuring troubled entities or their liabilities for free or at below market premium rates;
6.      contract process manipulation: takes place when a government ensures that a troubled entity obtains a government contract, typically by issuing a “no bid” or “sole source” contract;
7.      unwarranted deregulation: occurs when a government deregulates a troubled industry in order to increase its profitability, rather than from evidence that the former regulatory structure was unfair, inefficient, or otherwise deficient;
8.      liability forgiveness: is the name used when the government forgives the debts a troubled entity owes it;
9.      loans: are cash payments made by governments to troubled entities with the expectation of later repayment;
10.  loan guarantees: are the name given to repayment promises that governments make to private lenders to induce them to lend to troubled entities;
11.  market power creation: occurs when governments allow troubled entities to become more like monopolies and have more control over their input costs and/or the market prices of their output, as when they relax anti-competition laws or outright encourage the formation of price-fixing cartels;
12.  compensated nationalization: occurs when governments buy a controlling interest in troubled corporations from stockholders at above market prices;
13.  physical infrastructure improvement: is a type of bailout wherein a government provides a troubled entity with technology or physical capital, like manufacturing plants, for free or at below market prices;
14.  regulatory forbearance: is the process of relaxing the enforcement of existing regulations to make it easier for troubled entities to earn a profit;
15.  unwarranted research grants: are sometimes granted by governments to troubled entities to pad their revenues;
16.  securities purchases: occur when governments buy the bonds, equities, or preferred stock of troubled institutions;
17.  tariffs and other forms of protection from foreign competition: are used by governments to help troubled entities to compete against foreign companies;
18.  tax breaks: when granted by governments can render troubled entities profitable or at least ease strains on their expenditures.
Any of those types of bailouts can save a troubled company or industry from bankruptcy because they all entail a transfer of resources from one group, usually taxpayers, to another, the troubled entity or industry. The government and the bailout recipient usually justify the transfer by arguing that the recipient is too important to the economy to be allowed to go bankrupt because too many jobs will be lost and/or the financial markets will be too shaken to maintain economic output at current levels. Failure to bailout, then, will cause a recession that will hurt everyone’s pocketbook. A little money quote unquote invested in a bailout, governments and recipients claim, will save a lot of output and jobs. What a deal!
Many voter-taxpayers remain skeptical about such claims, so politics and ideology play large roles in the government’s choice of bailout type. Tariffs, for example, are much less popular than they used to be and hence are resorted to less frequently now than in the past. Outright grants of cash are usually used only by dictators. Officials who are beholden to voters, whether directly or indirectly, typically try to disguise the size and ultimate destination of resource transfers and hence prefer tax breaks, loan guarantees, regulatory forbearance, contract flexibility, and the other, more nuanced transfer types. When large bailouts are required, as in 2008, democratic governments regularly resort to outright loans and securities purchases, though the most capitalistic of them, like that of the United States, find it essential not to appear too quote unquote socialist when purchasing securities, so they will often opt for preferred shares that carry limited voting rights in corporate elections.
Bailouts of individual companies and even industries almost invariably work in the short term because they all entail resource transfers in one way or another. If Company X owes $50 million or $50 billion and the government gives them at least the sum owed, be it directly in cash, or indirectly via tax breaks, loan guarantees, cushy contracts, or whatever, the company surely can hang on for awhile. What is less clear is the long term effect of industry or individual company bailouts. Some industries, like steel, limped by for decades with aid from tariffs and other trade barriers but it isn’t clear that anyone except steelworkers, steel executives, and steel company shareholders benefited and according to some economists it would have been cheaper to just pay them off than to distort the economy with high tariffs.
Some companies, like Chrysler, rebounded nicely after receiving a bailout only to need another round of taxpayer aid a few decades later. Employees and other stakeholders gained but the overall economy might have been better served if Chrysler’s financial, human, and physical capital had been put to other uses in the 1980s. Other companies, like some of the defense contractors bailed out in the 1960s that I will discuss later, soon merged with larger entities, raising the question of who really benefited from the bailouts.
The morality of the bailout of large companies has also been questioned. Why is it more economically important to bailout a single, large corporation with 100,000 employees than it is to aid 1,000 companies with 100 workers each? Is it possible that they are equally important but that large corporations simply enjoy more political clout? How can the bailout of entire industries be justified? Should governments have bailed out horsewhip manufacturing industries in the early twentieth century? How about the makers of patent medicines containing heroin or cocaine? What to do with the producers of whale rib corsets, slave shackles, or gas light fixtures? Most would say the government should not have bailed them out but what makes savings bankers or steel or defense manufacturers any different? Aren’t bailouts of specific companies or industries simply a form of favoritism antithetical to the ideals of both the free market and representative government?
The Founding Fathers seemed to think so. In many of their diatribes against corporations, which began to form in unprecedented numbers soon after adoption of the Constitution, the Founders warned that quote unquote moneyed men could assume effective control of the government and use it to help further their business interests with a variety of subsidies, including emergency aid when they teetered on the brink of failure. The Founders well knew their Adam Smith, a major critic of corporations. It may seem strange that Smith, the first modern economist, distrusted corporations, the epitome of capitalist development, but he did indeed. Like colleges and churches, corporations skewed incentives in ways that caused, exacerbated, or perpetuated economic inefficiency. Smith believed that in quote every profession, the exertion of the greater part of those who exercise it, is always in proportion to the necessity they are under of making that exertion unquote. Corporations were not very good at eliciting effort and hence were doomed to leach off consumers as monopolies or to suffer at the hands of competitors, which of course induced them to seek government aid.
Smith believed that people tend to do precisely what they are rewarded for doing. If incentives are not properly structured, agents, which is to say employees, will injure the interests of their principals, their employers, by shirking, stealing, or causing other problems, especially in larger corporations where personal bonds are weakest. Salaried employees of corporations, Smith believed, would exert just enough effort to keep their jobs but no more because the value of any additional effort they might give would accrue to stockholders rather than themselves. That minimal effort was, Smith argued, sufficiently strong in corporations like canals, water utilities, insurers, banks, and other businesses that required little thought beyond routine tasks. Such weak incentives, however, would almost certainly crush a mercantile concern or other business that required flexibility, foresight, or strenuous effort.
Smith also believed that stockholders were unwilling or unable to improve incentive structures. The more numerous stockholders were, the bigger the free rider problem they faced. In other words, the bigger the temptation to wait for other stockholders to handle any problems that might arise. So Smith concluded, quote Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company unquote.
Due to the principal-agent problem inherent in the corporate form, many early European corporations found it difficult to remain profitable. Rather than go willingly into bankruptcy, most mobilized their workers, managers, stockholders, customers, and suppliers to beseech the government for aid. In Smith’s Britain, many were able to acquire monopoly privileges. Smith, and other eighteenth century political economists like James Steuart and Joseph Tucker, rightly disdained monopolies, especially permanent ones, because they maximized producer profits at the expense of consumers, who paid higher prices or received lower quality goods than they would in a competitive market composed of many producers.
            Corporations, Smith warned, were especially adept at manipulating government officials, a sentiment shared by conservative British politician Edmund Burke, who called the statute incorporating the East India Company quote a charter to establish monopoly, and to create power unquote while denouncing the company’s considerable influence in Parliament. Another British wit defined the corporation as a quote tyrannical, exclusive monopoly, generally consisting of gluttons, idiots, and oppressors unquote.
            Critiques like those exerted considerable influence on the Founders. In 1792, for example, Pennsylvanian George Logan argued that salaried employees were quote unquote uninterested Agents unlikely to work hard for their bosses or stockholders. Corporate managers, many early Americans feared, possessed both the will and the means to defraud stockholders, creditors, and customers. In 1827, an anonymous critic argued that corporations were quote made solely for the advantage of a few, and the probable injury of many unquote. In 1829, another anonymous critic argued that corporations had quote great opportunities of making their apparent means greater than their real funds, and of defrauding in other modes, and are liable to great mismanagement unquote. Another critic explained in 1837 that quote Human nature is the same every where, a man’s first and chief concern will be for his own [so] a man’s selfish interests will be first consulted, and will eat up the interests of his employers unquote. Others complained of two kinds of quote evils ascribable to mismanagement … directing their operation to subjects not within the proper sphere of institutions of this kind unquote and assuming too much risk in their proper sphere, thus quote encouraging a pernicious spirit of speculation unquote. Still others realized that managers could steal in a variety of ways, including self-dealing, empire building, and excessive borrowing.
Other critics argued that limited liability provisions induced stockholders to take excessive risks because quote they share all the gains, but are responsible for none of the frauds or losses unquote. For such critics, regulations contained few protections because they were quote for the most part drawn up by a cunning attorney … with so many invisible loop holes in it, that like a sieve, it lets out every thing they wish to get rid of, and affords ample space for the spirit of the instrument to evaporate entirely unquote.
It seems that the only the only thing that has changed from the Founding era is the expressiveness of the language used to describe substantially the same problem, the very real possibility that failing companies and industries will try to use their political clout to gain resource transfers that may not be merited. Do note, however, that the government need not be corrupt to give into their pleas as one of the human mind’s many foibles appears to be bias in favor of the things seen. When confronted with a bankruptcy, politicians and most of their constituents focus on the loss of votes, campaign contributions, taxes, and jobs if the company or industry is allowed to go bankrupt. They tend to forget that something else, maybe even something better, will arise in its place, much like the wildfires that actually rejuvenate forests and prevent them from suffering from much more destructive fires later on.
Systemic bailouts, like that orchestrated by the Federal Reserve in late 2008, are somewhat easier to justify than company or industry bailouts because they ostensibly help everybody. Their ultimate effects, however, are even more difficult to discern. In 2008, financial system meltdown appears to have been a real possibility, and as Federal Reserve chairman Ben Bernanke warned, a recession of Great Depression-like proportions could have ensued. When by 2010 it had become clear that the world economy was not going to collapse, Ben’s Fed appeared vindicated. As the global and U.S. economies remain mired in a low growth funk into at least 2013, however, some scholars are beginning to wonder if the cure wasn’t worse than the disease. According to this line of thought, the Fed cushioned the economy from disaster in 2008 and 2009 but at the cost of anemic growth for years, or even a decade or more. That might sound implausible but there is a recent, compelling precedent. The economy of Japan, you may recall, grew so robustly in the decades after World War II that by the early 1980s it appeared poised to take over that of the United States. Entire library shelves were devoted to books warning that America had either adapt Japanese ways, from educational systems to government subsidization of key industries, or lose an alleged economic war waging between the two nations. Those books are now laughable because in the late 1980s Japan suffered a series of major financial crises similar to those that rocked the United States in 2008. Rather than confront their problems and allow big companies to fail, the Japanese government chose to sweep them under the bailout rug. Japan’s economy didn’t crash but it remained largely stagnant for two decades and counting.
On the basis of that and other historical cases, some analysts argue that it might have been better in the long run if the U.S. government had allowed the financial system and economy to crash. The downturn would have been more severe, they suggest, but the rebound much stronger. The economy would be at more or less the same spot as it is today, but the trajectory would be sustainably upwards instead of sideways.
Others worry that when the U.S. economy pulls out of its doldrums, which barring catastrophe it will almost certainly do, sooner or later, the Bernanke bailouts will lead to a financial crisis so large and so severe that no bailout will be possible. The economy will then just not crash, it will burn along with our cities. Financageddon, the Apocafinancial, Financial Judgment Day, call it what you will. The key concept underlying that concern is called moral hazard, or, more formally, post-contractual asymmetric information. In simpler terms, some analysts worry that the government has, through repeated bailouts and policies like Too Big To Fail, essentially trained the leaders of big businesses to take huge risks as surely as rewarding lab rats with food pellets trains them to push on levers or respond to different colored lights. As John Allison, long-time CEO of BB&T Bank, notes in his recent book on the financial crisis, quote During my career, the Fed has systematically effectively encouraged banks to increase their leverage, sometimes intentionally, sometimes not unquote. To increase leverage is to take on more risk by borrowing, and then speculating with, other people’s money.
Bailouts are as old as the Republic itself but their frequency and scope have increased in recent decades, as has their capacity to spawn high levels of moral hazard. So analysts worried about high levels of moral hazard have a valid point but the American people must recognize that its government has the conceptual tool necessary to stave off financial system crashes while keeping moral hazard at a benign level. The only question is whether or not it has the will to re-activate the tool, which I will call Hamilton’s Rule but you may know as Bagehot’s Rule after Economist magazine founding editor Walter Bagehot, who explained the rule in his famous book Lombard Street. I call it Hamilton’s Rule because the nation’s first bailouts, orchestrated by Treasury Secretary Alexander Hamilton, were arguably the best in its history because they did not increase moral hazard, as evidenced by the several decades of financial stability that followed.
The first bailout entailed the assumption of state debts by the federal government, while the second entailed implementation of Hamilton’s Rule in response to the financial crisis now known as the Panic of 1792. Although assumption and the Panic of 1792 were not unrelated, as I will explain shortly, assumption did not cause an increase in moral hazard that led to the Panic, which instead marked the collapse of a classic asset bubble. United States bonds, Massachusetts state bonds, and shares of stock in the Bank of the United States, the Bank of New York, the Bank of Massachusetts, and the Bank of North America all trended higher in the months preceding the Panic. Whether the price increases were strictly rational or not I’ll leave to others debate. Here, I note only that asset prices increased to levels considerably higher than the prices of those same assets in London. Arbitrageurs stood ready to ensure that prices in the two markets would eventually equalize, net of transaction costs. But would prices in London increase or prices in the U.S. decrease, or some of both?
            Ultimately, the U.S. market was the one that corrected. Domestic investors had grown  too sanguine about the prospects for the nation’s economy. In 1791 and the first months of 1792, however, it was easy to be over optimistic. Just twenty years before, America had been a series of loosely-connected colonies linked more closely economically and politically to London than to each other. British overlords severely taxed colonial wealth, more so through the taxes implicit in their control of trade and monetary policies than through the petty explicit taxes on tea and what not that suffuse our legends regarding the causes of the Revolution. Just ten years before the Panic, America, by then at best a series of loosely-connected states, was essentially bankrupt. After six years of intense rebellion, civil war, and naval blockade, its economy was in shambles, its future so uncertain that government paper money and bonds traded at just a fraction, often a small fraction, of their face value while economic output stagnated.
            The turning point came in 1787 at the Constitutional Convention. The Constitution, the public discourse that led to its ratification, and the subsequent passage of the Bill of Rights laid the foundation for prosperity. Now endowed with a vigorous federal government that contained internal and external checks sufficient to quash anything smacking of tyranny, Americans could rest relatively assured that their lives, liberties, and properties would be safe from the clutches of any government, be it local, state, national, native, or foreign.
            Nor was the Constitution the only reason for optimism. Led by Hamilton, the new national government took positive steps to ensure that Americans’ pursuit of property would be successful. First, it established an income stream comprised of revenue tariffs supplemented with excise taxes and land sales. Next, it refinanced its confusing debt load by issuing three new types of easily negotiated federal bonds. In the process, it relieved the debt burden of the states, allowing them to lower taxes, another boon to the economy. Assumption of state debts, as the policy was called, was essentially a federal bailout of state governments but it did not increase borrowing by state governments, which were informed in no uncertain terms that profligacy would not be countenanced. When state governments defaulted on their debts following the Panic of 1837, the federal government stayed true to its promise and did not bail the states out again even though its inaction injured its own credit standing in European markets.
In the 1790s, tariff receipts serviced the new federal bonds and met the government’s annual expenditures. To help the federal government to borrow to meet temporary revenue shortfalls, to shift funds from point of collection to point of expenditure, and to disburse interest payments on the new federal bonds, Hamilton sponsored the creation of a largely privately-owned central bank, the Bank of the United States. At the same time, federal and state governments also signaled a willingness to support development of business corporations in general and the domestic industrial and financial sectors in particular.
            Upon this firm foundation, and with strong demand for U.S. agricultural goods and bonds in Europe, businesses of all sorts thrived. Commerce quickened; deals to buy, sell, build, and rent proliferated. Thanks to specie inflows and easy credit terms at the banks, the per capita money supply surged to about 8 dollars, up from 6 dollars. According to an early money demand function called the United States Financial Money-Meter, that increase in the money supply should have decreased the market interest rate on good private loans to about 6 percent per year, which indeed was approximately the rate achieved on the eve of the Panic. Yields on U.S. 6s, federal bonds that paid interest quarterly at the rate of 6 percent per year, were even lower than 6 percent because of the national government’s newly established but strong credit rating. At $8 per capita, the money meter correctly predicted, commerce would flourish, industry and agriculture would gain, and even frontier lands would increase in price. Importantly, the increased stock of money did not lead to significant price inflation of consumer or producer goods.
            The fly in the ointment was that some of the U.S. money stock, indeed probably a good deal of the $35 million or so dollars in circulation, was composed of bank liabilities, specifically banknotes and checking deposits. Banknotes and deposits were credit instruments. The holders of the notes and deposits were, in essence, making loans to their banks, which in turn made loans to businesses. The problem was that any shock that made people distrust banks, or made banks distrust businesses, would reduce the money supply. As the money meter predicted, a rapid decrease in the per capita money supply would increase interest rates, which is to say decrease bond prices, depress equity prices, and curtail overall business activity. Indeed, equities were hit with a double whammy -- expected future income streams decreased AND were discounted at a higher rate. Those shocks, in turn, generated yet more mistrust of banks and borrowers, giving more momentum to the deflationary spiral. With no obvious end in sight, it was little wonder that people literally panicked when it became clear that a monetary restriction had begun.
            We do not know for certain what triggered the deflationary spiral that seized the U.S. economy in early 1792. Clearly, the banks began to reduce their volume of lending. On 31 January 1792, the Philadelphia headquarters of the Bank of the United States had almost $2.7 million dollars worth of loans to businesses on its books. By 9 March, that figure had dropped to less than $2.1 million, a reduction of about 23 percent. The restriction apparently began in early February; its effects were already being felt by mid-month when Philadelphia broker Clement Biddle noted that quote cash grows very scarce from both the Banks withholding discounts unquote. About that time, Philadelphia’s other bank, the Bank of North America, began to increase its loans again but by the end of February it had curtailed lending yet again. By the beginning of March, the Bank of New York had also reduced its lending. According to one of its directors, Daniel McCormick, the Bank of New York quote this week for the first time refused all new paper and made all old ones pay up a part unquote. The banks in New England and Baltimore also appear to have reduced the volume of their lending in February and early March.
            Whether the banks curtailed because they sensed problems with borrowers, or because noteholders and depositors sensed problems with banks, or both occurred simultaneously, we may never know. We do know that noteholders did not run on the Bank of the United States in Philadelphia, which had almost $887 thousand dollars in circulation on 31 January and almost $892 thousand dollars in circulation on 9 March. But according to McCormick, the fact that the notes of the Bank of the United States did not circulate at their face value as widely as first expected caused the bank to curtail its lending. The Bank’s notes indeed circulated at a discount that increased with their distance from Philadelphia. Before the opening of the Boston branch, for instance, Bank of the United States notes traded at a 2 to 5 percent discount in eastern Massachusetts. The discount reflected the transaction cost of remitting the notes to Philadelphia for their redemption into gold and silver and not the institution’s credit rating, but the Bank’s directors apparently were not taking any chances.
Depositors may have played a role too. Government deposits increased from just over $467 thousand dollars on 31 January to a few dollars shy of $600 thousand in March. But individual deposits shrank from almost $812 thousand dollars on 31 January to less than $570 thousand in March. Some of those deposits may have disappeared as borrowers repaid loans, but others may have been physically withdrawn from the bank’s vaults. The Bank of the United States was clearly losing reserves -- its cash on hand dropped from $510 thousand dollars to $244 thousand between the January and March balance sheets. Whatever the ultimate cause of the reserves drain, its impact was dramatic. On 29 December 1791, the Bank’s Philadelphia headquarters had reserves of $706 thousand against demand liabilities of about $1.2 million, a very conservative reserve ratio of 60 percent. On 31 January, by contrast, the Bank’s reserve ratio had dropped to 23.5 percent. By 9 March, the ratio stood at a mere 12 percent. On 23 February, a one “Curtius” pointed to the Bank’s quote limited specie capital unquote in a diatribe that appeared in the New York Daily Advertiser. His claim that the Bank had only about $250 thousand dollars in specie reserves was eerily precise.
The big drop in loans and the money supply raised interest rates and hence lowered bond prices. The conduit was direct: borrowers had to sell securities to raise the cash they needed to repay their bank loans. Many sellers and few buyers spelled lower prices, 20 percent lower at their nadir. Similarly, numerous borrowers and few lenders spelled extremely high interest rates, as high as 144 percent per year, on personal loans. Over-leveraged speculators, like the infamous William Duer, were the first to succumb to bankruptcy. Their failures of course threatened the solvency of their creditors, who in turn owed money to yet others until no one’s credit was above reproach. As the newspaper the New York Diary reported on 27 March, quote Money is scarce, and confidence between man and man almost wholly destroyed unquote.
The first few weeks of the panic were as dire as a wolf. On 19 March, George Cabot told fellow Massachusetts financier Israel Thorndike that the failure of speculators quote may create distress among the poorer classes unquote. Cabot warned that quote Should this happen, a popular commotion might be the consequence. Should the embarrassments on circulation increase or even continue for anytime, it may be justly apprehended that the public indignation will break thro’ all restraint & demolish all the money systems of the country unquote.
But before the financial system degenerated, two powerful forces stepped in to stymie the panic and to bolster prices. The first was Alexander Hamilton and the second was the market itself. To restore confidence, Hamilton injected money back into the economy. He did so in several ways. First, he asked the Bank of New York to make open market purchases of government debt on the Treasury’s behalf. Those timely purchases bolstered securities prices and increased the money supply. Second, Hamilton extended credit to purchasers of the government’s guilder-denominated bills of exchange, the proceeds of a timely Dutch loan, if they posted government bonds as collateral. The policy increased demand for U.S. securities and decreased demand for cash.
Hamilton also encouraged the nation’s banks to begin lending again, but only on the solid collateral of government debt and at a higher rate of interest than before the panic. By the end of March, the Bank of New York began to extend its loans upon deposits of government securities. By mid-April, the cashier of the Bank of the United States stated that the bank would make quote as liberal an extension of credit as the funds of the institution & other circumstances will admit of unquote. His pronouncement was not mere rhetoric. By 22 June, the Bank of the United States in Philadelphia had extended its discounts to almost $2.5 million dollars, nearly matching the pre-Panic high.
Soon after Hamilton restored a modicum of confidence, people with ready cash began to spot bargains. At slightly less than par, for instance, U.S. Six percent bonds yielded more than 6 percent per year, guaranteed. Many Southerners found it difficult to pass up such deals. As they bought, the price of Sixes and other assets rebounded. By late April or early May, prices had come off their lows and stabilized.
No recession ensued, which is not very surprising given the Panic’s short duration and Hamilton’s decisive response. More interestingly, the financial system remained remarkably stable until the end of the War of 1812. Only a couple of banks failed and that was due solely to the malfeasance of a single man. The reason for the long spell of stability is that Hamilton’s response to the Panic, what I have called his rule, and what would later be called Bagehot’s Rule, did not increase moral hazard, or risk-taking on the part of financiers. What Hamilton did was instruct the lender of last resort, the Bank of the United States and the Bank of New York, both of which he had helped to establish, to lend to anyone who could post good collateral at a penalty rate and allowed everyone else, including his friend William Duer, to go bankrupt. By immediately separating the bankrupt companies from those that were merely finding it difficult to borrow the cash they needed to remain in operation, the Rule immediately stopped the emotional, panicked selling that fed on itself and threatened to destroy the market’s inherent rationality. That allowed those on the sidelines with cash to step in and buy assets and thereby drive prices back up to their rational level. The penalty interest rate was not punitive but merely ensured that anyone who could borrow at less than the penalty rate from a lender other than the lender of last resort would do so.
Nothing in human affairs works perfectly all the time, but Hamilton’s Rule comes close and should therefore guide all future systemic bailouts. It was never consciously abandoned by policymakers but merely forgotten due to decades of disuse. Before the Great Depression, the U.S. government minimized bailout expectations by providing emergency aid on very few occasions. In addition to the 1792 effort just described, in 1825 Nicholas Biddle, as president of the second Bank of the United States, successfully prevented a financial crisis from spreading to America from Britain by following Hamilton’s Rule. Between the demise of the second Bank in 1836 and the opening of the Federal Reserve in November 1914, the Treasury did little to stop financial panics beyond depositing some of its funds in money center banks. Private lenders of last resort, including bank clearinghouses and investment bankers, filled some of the void but Bagehot himself called the quote American system … faulty in both its very essence and principle unquote.
Government takeovers of privately-owned transportation corporations became increasingly frequent after the Civil War but few could be considered bailouts because stockholders received little or no compensation and the improvements were turned over to municipal governments. Most were, in other words, uncompensated nationalizations. During the infamous Gilded Age, the federal government subsidized railroads with land grants and other concessions and manufacturers with tariffs but few of its actions could be considered bailouts, which were politically anathema and, in an age of dynamite-throwing anarchists, potentially physically dangerous for recipients. Most Americans did not consider bailouts in the general interest or sanctioned by the U.S. Constitution. Several state constitutions even explicitly forbade state governments from lending to, or guaranteeing the debts of, individuals or businesses and many Americans considered waves of commercial bankruptcies salutary. One of them argued quote As one after another goes down, there is one less engaged in the scramble for money, and the survivors experience the same sort of relief as men in a crowd do when some of them faint and are carried out unquote.
U.S. government bailout activity increased dramatically in the twentieth century due to the stresses caused by World War I, the Great Depression, World War II, the Cold War, and the demise of fixed exchange rates in the early 1970s. Initially, bailout expectations remained low but by the early twenty-first century decades of bailouts had increased bailout expectations and thereby induced more risk-taking which, in turn, increased the number and severity of crises and hence the need for yet more bailouts. That pernicious feedback loop began to develop, slowly, as early as World War I. The War Finance Corporation was more of a general subsidy program than a bailout vehicle per se but it did incidentally aid distressed companies. Moreover, it set a precedent for the New Deal’s Reconstruction Finance Corporation or RFC. At first, the RFC made loans only to distressed financial institutions and railroads but the government soon allowed it to lend to distressed municipal governments and manufacturers as well. Many New Deal programs can be interpreted as attempts to bail out specific groups, including banks by the Federal Deposit Insurance Corporation, farmers by the Agricultural Adjustment Agency, financiers by the Securities and Exchange Commission, homeowners by the Home Owners’ Loan Corporation, and various other entities through cartelization, price supports, and other anti-competitive measures sponsored by the National Recovery Administration.
Although unprecedented in scale and scope, New Deal bailouts were seen as aberrations and hence did not radically increase bailout expectations. Moreover, the RFC essentially followed Hamilton’s Rule because it lent at a penalty rate and under stringent collateral valuation rules. According to a late New Deal monograph on government corporations like the RFC, quote the protection of government credit cannot be implied unquote. In other words, unless an explicit guaranty was included in the act, the Treasury would not be held responsible for the debts of government-owned and operated corporations, much less private businesses. By the 1980s, by contrast, investors believed, rightly as it turned out, that the bonds of government-sponsored enterprises like Fannie Mae and Freddie Mac were de facto backed by the full credit of the U.S. Treasury even though Congress had not authorized an explicit guarantee. Just thirty years later, many lenders believed that taxpayers would reimburse them if any foreign government or large private corporation, financial or not, defaulted. By then leading experts on central banking publicly wondered if quote monetary policymakers might be tempted to ‘follow the markets’ slavishly, essentially delivering the monetary policy that the markets expect or demand unquote.
The sea change in sentiment occurred because during and after World War II the U.S. government became an increasingly potent economic force. Under the Bretton Woods system of fixed exchange rates, the Federal Reserve began to actively manage the domestic money supply or interest rates. American governments at all levels stepped up the direct regulation of prices -- during the war, during the Nixon administration, and with rent controls and minimum wage laws -- and increasingly attempted to mandate specific economic outcomes. The public and private sectors became, in the words of one researcher, so quote completely intertwined [that] no clear distinction unquote between them could be made. In 1970, for example, the government awarded Penn Central Railroad $125 million in loan guarantees while it was in bankruptcy because it considered the company a public utility that provided rail service rather than a private business. Shortly thereafter, the troubled Conrail received $3 billion in aid for essentially the same reason.
Perhaps the most important example of the melding of government and business interests, however, was the so-called military-industrial complex that emerged from World War II and matured during the Cold War. Close ties between the Pentagon and its arms manufacturers created a cadre of mismanaged defense contractor firms that believed that quote if adversity strikes unquote they could count on government bailouts. Some defense contractor bailouts were completed quietly through the award of major contracts of dubious necessity, some as aid to foreign allies, some as contractual modifications favorable to the distressed firm, and some as new, comfortably-padded contracts. A few, like the government’s $250 million loan guarantee for Lockheed in 1971, were explicit and justified on the grounds of employment and national defense.
Senator William Proxmire warned Treasury Secretary John Connally that quote Lockheed’s bailout … is not a subsidy … it is the beginning of a welfare program for large corporations unquote. He correctly perceived that an important corner had been turned. Lockheed and other bailouts, including the so-called special tax relief extended to the American Motor Corporation in 1967 and large loan guarantees and import restrictions provided to dying steel companies in the 1970s, prompted Chrysler to ask for federal assistance when it faced bankruptcy in the late 1970s. Chrysler chairman Lee Iacocca justified his aid request by arguing that quote free enterprise died a while back [and that the bailout was] amply precedented unquote. Although Chrysler’s case was arguably much weaker than those of previous bailout recipients, the government relented, ostensibly because the scorn of unemployed workers would be more powerful at the ballot box than the gratitude of those taking the new jobs that would have been created eventually if Chrysler had been shuttered.
Chrysler’s aid package, worth an unprecedented $3.5 billion, further pried opened the lid of what several analysts called a Pandora’s Box of bailouts. Increasingly un-sticky expectations about the government’s willingness to provide emergency assistance induced yet other troubled firms to seek government bailouts and they of course quote cited the Chrysler bail-out as a plausible reason why they ought to have one unquote. A wave of bailout requests, some successful, ensued. For example, manufacturers of TRIS, a flame-retardant chemical banned from use in children’s sleepwear after its carcinogenic properties were discovered, successfully lobbied for federal funds in late 1982. In 1984, the government bailed out forest product companies that had bid too high for timber cutting rights. Soon after, Dennis Carney, the president of a bailed-out steel firm, claimed that quote you can’t win the game with free enterprise anymore unquote and Wharton professor Edward Herman sneered that the government had birthed a form of quote unquote crybaby capitalism that rewarded the most vocal complainants. By the mid-1990s, the federal government had bailed out over 400 non-financial corporations and its support of distressed defense contractors continued. The number and size of sovereign and municipal government bailouts, like the loan guarantees granted to New York City in 1975 and 1978, also increased in the 1980s and 1990s.
After a long postwar lull during which only a handful of tiny banks failed due to the bank cartelization bailout implemented during the New Deal, inflation, technological change, and overly ambitious deregulation began to take its toll in the 1970s and 80s. Unsurprisingly, bank failures increased in number and size and bailouts followed, mostly in the form of Federal Deposit Insurance Corporation purchase and assumption agreements and Federal Reserve lender of last resort actions. Union Bank succumbed in 1971, Bank of the Commonwealth in 1972, Franklin National in 1974, and First Pennsylvania Bank in 1979. Those bailouts overwhelmed the effect of two potential bailouts that didn’t happen, Penn Square and Seafirst, increasing the bailout expectations of bankers and inducing them to, as one researcher bluntly stated, quote take riskier actions than if government intervention was unlikely unquote. By the early 1980s, bankers had responded to the changed circumstances by giving up expensive equity in exchange for low-cost implicit insurance provided by the expectation of government bailouts. The bailouts, most of which left even uninsured depositors unscathed, also greatly reduced large depositors’ incentives to monitor their banks’ activities.
In the 1980s and early 1990s, the trickle of bank failures became a torrent. The entire S&L industry collapsed, Continental Illinois failed, the Bank of New England reeled under bad real estate loans, and Citibank wavered on the brink of insolvency only to find new life in South Dakota of all places. All received bailouts, ranging from regulatory forbearance to Fed discounts to FDIC guarantees of uninsured deposits to the purchase of underperforming assets by a taxpayer-funded bad bank, the Resolution Trust Corporation. In 1987, the Farm Credit System, a government sponsored entity or GSE, also received a $4 billion bailout. In all, over $150 billion, or some 2 percent of GDP, was redistributed from taxpayers to bank stockholders, executives, and creditors.
New legislation, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corporation Improvement Act of 1991, attempted to limit future bailouts by reducing regulators’ discretion about when and how to resolve failed banks. The government also refused to bail out junk bond giant Drexel Burnham in 1990 and both MJK Clearing and Superior Bank in 2001. Those exceptions and the new laws, however, did little to decrease market participants’ belief that the government intended to follow a policy of Too Big to Fail. Beginning with the 1984 bailout of Continental Illinois, policymakers explicitly promised free, unconditional aid to the eleven, and later a deliberately ambiguous number, of the largest banks, and later financial institutions of any sort, under the supposition that they were too big, important, or interconnected to be allowed to go bankrupt. The assumption that big financial institutions would not be allowed to fail contributed to imprudent lending, as did the erosion of economic incentives, especially the franchise value of financial institutions, that had traditionally limited risk-taking.
Incentives within financial institutions also deteriorated. To overcome the agency problems that had plagued them since the days of Adam Smith, corporations in the 1990s began paying executives big bonuses based on their stock price. The new incentive system worked too well. As Smith himself would have predicted, executives began artificially boosting stock prices with accounting shenanigans like that at Enron or by taking excessive risks with corporate assets. They were, after all, playing an I win, you lose game. If their risks paid off, they received a huge annual bonus, enough to sustain them in luxury for their entire lives. If their risks didn’t pay off, the government bailed out the company and they could slink away, sometimes into retirement but often into another job, often with millions in so-called golden parachute compensation.
Financiers had also learned that they could maintain high levels of risk regardless of their company’s size or the macroeconomic climate because if the entire financial system encountered difficulties the Fed stood ready to provide ample, timely, and inexpensive aid. Instead of following Hamilton’s Rule as it traditionally had at least given lip service to, the Fed under Alan Greenspan at the outset of crises increased market liquidity by purchasing bonds in the open market and lowering both the overnight bank-to-bank target interest rate and the rate it charged banks at its own discount window. Relaxation of Hamilton’s Rule increased moral hazard and risk-taking at all banks and Too Big To Fail policy induced financial institutions to grow large as quickly as possible to receive the free insurance. In 1987, the Greenspan Fed stopped a stock market rout by supporting banks that lent to distressed broker-dealers. In 1997 and 1998 it lowered interest rates in response to the Asian financial crisis, the Russian default, and the failure of Long-Term Capital Management, the sale of which Greenspan brokered and implicitly guaranteed. The Fed also injected cash into the economy in late 1999 to prevent panic in the event of Y2K-related problems and did so again in the wake of the terrorist attacks in September 2001. More dubiously, the Fed lowered interest rates for a considerable period to buffer the economy, and investors, from the bursting of the dotcom bubble in early 2000. In addition to increasing confidence in the existence of a so-called Greenspan put, long periods of low real interest rates invited increased leverage and other forms of risk-taking implicated in the subprime mortgage crisis of 2007, the immediate trigger of the 2008 panic.
Under Greenspan’s successor as Fed chairman, economist Ben Bernanke, the Fed also reduced interest rates when trouble struck, eventually lowering nominal overnight rates to zero and keeping them there at least into 2013. As the intractability of the subprime mortgage crisis became increasingly apparent, the Fed invoked its emergency authority under section 13-3 of the Federal Reserve Act, which granted it broad powers during quote unquote unusual and exigent circumstances, to implement an unprecedented array of novel policies, most of which did not impose large direct burdens on taxpayers. The guarantees involved in the sale of investment bank Bear Stearns in March 2008, however, exposed taxpayers to up to $29 billion in losses and seemingly extended Too Big To Fail expectations to all large financial institutions.
During the crisis of September 2008, federal regulators made several crucial mistakes that deepened the panic significantly. Their worst sin was arguably the one least emphasized by the news media, the decision to provide 100 percent cover to the uninsured deposits in Washington Mutual by taking the money out of the hides of WaMu’s bondholders. The action was technically legal, apparently, but it was unprecedented and it frightened many investors who realized that regulators could do basically anything they wanted. People, not laws, ruled the day and some of those people, like Treasury Secretary and ex-Goldman Sachs CEO Henry Paulson, apparently were not above favoritism. So the bond market dried up for all banks overnight.
When regulators broke the agreement that allowed Citigroup to buy Wachovia, capital market participants, in John Allison’s words, quote now knew, with certainty, that the FDIC, the Fed, and the Treasury were not only incompetent but untrustworthy. They could not even be relied on to execute their agreements unquote. The only rational response was to hide.
A third major mistake that also discouraged new investment was regulators’ failure to loosen strict mark-to-market accounting rules. So-called toxic assets were not, at first, truly toxic in the sense of being untouchable. For the right price, buyers with cash on hand, and there were many, stood ready to make purchases at rational prices and thereby stabilize the market, as they had done in 1792. But in 2008 and 2009 they were handcuffed by mark to market accounting rules that could have ruined them if asset prices for some reason didn’t stabilize. So cash stayed on the sidelines and the markets appeared to quote unquote freeze up, which was the justification for the alphabet soup of Federal Reserve and Treasury bailouts that soon ensued.
A fourth major mistake was the Troubled Asset Relief Program, more commonly known as TARP. The government forced healthy banks to accept TARP funds for several reasons. First, it wanted to avoid the political backlash from bailing out just the big bad boys. Second, it wanted to avoid stigmatizing them, lest their liability holders – their depositors and other lenders – withdraw their funds precipitously. Third, it wanted to quote unquote prove the measure a success, so it offset losses to bad banks with earnings from the good ones that it forced to participate. The program was, in effect, a subsidy to unhealthy banks paid by prudent ones. The lesson to John Allison, BB&T CEO, was clear: quote Take high risk in the good times because the government will save you in the bad times. … Being conservative is a losing strategy. There is no long-term reward for not taking irrational risk. unquote
If other bankers absorbed this same message -- and how could they not? – the economy is in for another big shock coming out of the financial sector. It might not be tomorrow, or next year, but within our lifetimes it will happen again unless we take decisive action soon. I want to convince you, and through you America’s policymakers, that when it comes to systemic bailouts, Hamilton’s rule should be followed because it minimizes moral hazard, or in other words the incentive to take big risks, and hence reduces the likelihood that future financial calamities will terrorize America’s taxpayers and workers, regardless of the metaphorical color of their collars. It also means that there will be a clear rule of law in place and that will decrease regulatory discretion and hence favoritism. What adoption of the Hamilton Rule means in concrete terms is that the Federal Reserve, or other lender of last resort, should make clear, now, that in the event of financial market crises it will only make emergency loans to entities that can post good collateral, like government bonds or highly rated corporate commercial paper, and will do so at a rate higher than that which prevailed at the outset of the panic or other emergency. So no solvent entity, financial or non-financial, will have to fear bankruptcy but nobody should expect years of easy money to follow a crisis.
Entities that cannot post good collateral, by contrast, will be placed into bankruptcy, regardless of their size, the potential risk to counterparties, and so forth. In addition, corporate executives will not receive bonuses if their companies fail and in fact they may lose compensation that they have already received and, if they have committed criminal acts like fraud, their entire estates and even their liberty will be at stake.
Apologists for large, speculative financial interests will complain that such a rule is too harsh, that it will make financial institutions too timid to drive economic growth. My response is that finance is not supposed to be a high stakes game, it is supposed to be about rational investment in the future, in pooling and hedging, which is to say reducing risks, and in financing business projects that promise to prove profitable. If your most innovative and profitable companies are in finance, your economy is in deep, deep trouble. Go back to the basics, as South Dakota has done, and encourage real entrepreneurship by limiting government to the protection of life, liberty, and property. Businesses, charities, families, and a lender of last resort following Hamilton’s Rule can take care of the rest. Thank you.

Robert E. Wright, ed. Bailouts: Public Money, Private Profit Privatization of Risk Series, Social Science Research Council (New York: Columbia University Press, 2010).
Robert E. Wright. Government Bailouts.” In Robert Whaples and Randall Parker eds., Handbook of Major Events in Economic History (New York: Routledge, 2013): 415-27.

No comments: