An International Perspective on the US Bailout

As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many countries in the developing world have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalization and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalization by itself did not generate crises: government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not that different.

In the current debate, pundits are railing against the enormity and unfairness of the US bailout, not to mention the bad precedent it will set. Many also point to financial deregulation as a key cause of the crisis. But the facts suggest otherwise. First, the size of the bailout is within historical and international norms. Second, financial liberalization and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relatively to European Union countries. The development of new financial instruments has helped finance the IT revolution and the large-scale increase in home ownership. Both factors have been powerful engines of US growth. Third, policy interventions, such as the effort by some in the administration and Congress to induce Fannie Mae and Freddie Mac to move into the subprime mortgage market, have largely paved the road to the financial crisis the US faces today.

How big is the current US bailout compared to other bailouts? The $700bn bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues –Bear Stearns, Freddie Mac and Fannie Mae, AIG– the total bailout costs could go up to $1,400bn, which is around 10% of GDP. In contrast, Mexico incurred 18% of  GDP in bailout costs following the 1994 Tequila crisis. In the aftermath of the 1997-98 Asian crisis the bailout tag was 18% of GDP in Thailand and a whopping 27% in South Korea. Somewhat lower costs, although of the same order of magnitude, were incurred by the Scandinavian countries in the banking crises on the late 1980s: 11% in Finland (1991), 8% in Norway (1987) and 4% in Sweden (1990). Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of  GDP.

The bailout costs that the taxpayers are facing today can be seen as an ex-post payback for years of easy access to finance in the US economy. The implicit bailout guarantees against systemic crises have supported a high growth path for the economy –albeit a risky one. In effect, the guarantees act as an investment subsidy that leads investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors –such as housing, small businesses, internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government will make sure they get repaid (at least partially).

Importantly, there must be systemic insolvency risk for the bailout scheme to have these effects. This is because a bailout is not granted if an isolated default occurs, but only if a systemic crisis hits, since only under the threat of generalized bankruptcies and a financial meltdown would Congress agree a bailout. Thus, an investor will be willing to take on insolvency risk only if many others do the same. When a majority of investors load on insolvency risk, they feel safe (because of the bailout guarantee). No wonder many financial firms end up with huge leverage and loaded with risky assets. In the Tequila and Asian crises the risky bet was the so-called currency mismatch, in which banks fund themselves in dollars and lend in domestic currency. In the US it took the form of toxic mortgage-related assets. No innocent souls here. Borrowers, intermediaries, investors and regulators understood the bargain. At the end, the bailout guarantee scheme has succeeded in inducing more investment by financially constrained agents in real estate and small businesses.

Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today, and the IT sector in the late 1990s.  But the bottom line remains that risk-taking has positive consequence in the long run even if it implies that crises will happen from time to time. Over history the countries that have experienced –rare– crises are the ones that have grown faster.[1] In those countries, investors and businesses take on more risks and as a result have greater investment and growth. Compare Thailand’s high-but-jumpy growth path with India’s slow-but-steady growth path before it implemented liberalization a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per-capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.

Some argue for the rolling back of financial liberalization and for a return of the good old days of strict regulation. Not so fast! Today’s bailout price seems high. But is it that much relative to the higher growth the US has enjoyed in specific sectors and overall? Let’s wait for the final price tag. Other countries’ experience tells us that financial liberalization –and some of its consequences– ain’t such a bad idea after all. They also teach us the importance of jump starting quickly the lending engine so as to avoid a growth collapse, and for the regulatory agencies to refrain from killing the natural risk-taking process that accompanies the resumption of credit growth.

[1] See Romain Rancière, Aaron Tornell and Frank Westermann, 2008. “Systemic Crises and Growth,” The Quarterly Journal of Economics, MIT Press, vol. 123(1), pages 359-406, 02

5 Responses to "An International Perspective on the US Bailout"

  1. Anonymous   October 16, 2008 at 9:48 am

    This is a highly ideological argument in two ways. Firstly, it takes evidence from presumably capital poor developing countries as a guide to outcomes in the US. Secondly, it makes no attempt to look at the distributional considerations underlying the argument.The problem with bailouts is not so much that they cost as that they are a transfer of resources from the general population to very high-earning individuals with shares in the financial sector. The high risk high growth of the last two decades was also growth characterised by substantial rising inequalities. So, we need to know not just about growth in the aggregate but also about distributional impacts before we can make blanket statements about the advantages of high risk financial practices….advantages to whom???Finally, the idea that all this growth was a self-conscious moral hazard play is ridiculous. It only makes sense if you have a previous ideological commitment to rational expectations models of financial markets. It is much more logical simply to conclude that financial markets can’t price risk properly.

  2. Anonymous   October 16, 2008 at 3:40 pm

    I agree that is analysis is fundamentally flawed if only based on the numbers. The FINAL bailout costs will be more to the tune of U$4+ trillion. That’s 40% of US GDP. The real US GDP is approx. U$9 trillion. The U$14 trillion is hocus, pocus, bogus – just like the inflation, unemployment & other numbers.Of this U$9 trillion GDP, 73% is based on debt based consumption fueled by borrowed funds from outside the US. Of the remaining U$6.6 trillion, over U$1 trillion goes toward the military/security complex. Throw in other non-productive, non-wealth creating sectors such as financial services, legal services & other myrid non-productive activities that get lumped into the US ‘Service’ economy & the real productive, wealth creating sector is no more than U$4 trillion max. Also, take into account that the US GDP is currently shrinking & the picture is not pretty.

  3. Guest   October 17, 2008 at 10:00 am

    …and I always thought that the growth of the U.S. economy was due to excessive debt-making, which cannot go on forever.

  4. Darkie   October 17, 2008 at 1:00 pm

    I’m glad to see criticism of this superficial and tendentious viewpoint. There is no account made for the consumption contraction and its domestic US and international facets. BWII and the dollar’s international role is nowhere to seen in this abstract unstructured comparison. The debt-based “GDP” is another deceptive figure in this analysis. Furthermore, it takes final figures and conflates them with initial figures for what is rapidly becoming a multi-trillion dollar disaster. In sum, a sunny, well-fed caricature at the center of “hundred hurricanes” and totally out of tune with the forward-looking tendencies in Latin America and elsewhere.

  5. gAnton   October 17, 2008 at 1:37 pm

    “Putting Lipstick on a Pig”, or “If You Dress a Monkey in a Brooks Brothers Suit, he Continues Being a Monkey”(In what follows, “they” refers to Hank Paulson and Ben Bernanke.)I have two fundamental criticisms of the US reaction to economic crisis, both of which, of course, interact:1. They lack perspective; They have no idea of how long this “crisis” is going to last. (The word “crisis” connotes a very difficult short term situation, as if you could just get a heart attack victim through the next several days, the situation will become manageable.) All of their actions are as if today’s problem is the last problem, and they have no concept of pacing or reasonable and proportionate allocation of resources to the current problem. They think in terms of days and weeks instead of months and years.2. The treat symptoms instead of causes. For example, recently on several occasions, when the stock market was plunging on very bad news, it suddenly jumped 500 points or so for no good reason (in spite of continuing bad news and the fact that all other world stock markets continued plunging). They were obviously manipulating the stock market instead of addressing the fundamental issues that were causing world stock markets to plunge (they were putting lipstick on a pig, and I’m sure that it was a very expensive lipstick that they were using). Part of their problem is they overemphasize the importance of of market psychological factors (e.g. market panic)–sort of like throwing a drowning man a bottle of tranquilizers.The terrible result of their over-emphasis on and over-reaction to current situations is that longer range problems that could be anticipated and prevented are no longer being addressed. Further, if thay keep throwing fortunes at symptoms, they’ll increase inflation and crash the dollar.