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.
Sources:
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.
