Why government responses need to be comprehensive and coordinated

The Lehman Brothers story has shown two things – banks cannot be simply allowed to go bankrupt and a piecemeal approach will not bring banking systems back into minimal functioning condition. The lesson is that there will have to be a bailout. The contagion from the US to Europe and now to most other parts of the world further shows that the bailout will have to be global. The question is how to do it and who will bear the cost.

Four measures are jointly necessary to clean up the financial mess:

  1. Absorb significant amounts of toxic assets (and each day’s fall in stock prices widens the definition of toxicity);
  1. Recapitalise banks;
  1. Restart the interbank market;
  1. Prevent bank runs by guaranteeing all deposits.

There are many ways of proceeding with each measure. For example, debt-for-equity swaps can achieve the third and fourth measures. Effectiveness is a key consideration, of course, but it is not the only one. The cost of the bailout, likely to amount to many percentage points of GDP, matters greatly. Nor can we ignore the moral hazard component since it matters greatly for the future and, more ominously perhaps, since the long-run political implications of the crisis will be deep.

The Paulson plan deals with the first measure. The British plan deals with the second and third measures. Decisions taken in Ireland, Germany, Greece and Austria deal with the fourth. Most European countries seem to be determined to operate on a case-by-case basis. A comprehensive plan remains to be adopted anywhere in the world.

An essential ingredient is that taxpayers get a fair share of the upside. The British plan achieves this but in a modest way, as preferential shares limit both the up and the down sides. The Paulson plan is likely to take off only if the toxic assets are bought above current market value, which limits the upside and increases the downside. European-style case-by-case bailouts mostly involve regular shareholding, with significant up and down sides.

One reason why governments adopt partial measures is that they fear their costs. This is a mistake. The cost of the sum of the four measures is most likely to be significantly lower than the sum of each measure’s potential cost. Importantly, a comprehensive plan that includes all four measures raises the probability of success and therefore the odds that the upside will materialise. Thus, a comprehensive plan should encourage governments to emphasise measures that increase the upside.

It is very unlikely that one country will be able to salvage its banking system if others fail. Indeed, if some significant countries fail to respond adequately, the crisis may well worsen and, at the very least, raise the cost of the bailout for those countries that got it right.

Banks, which have been so good at regulation arbitrage, will indulge enthusiastically in bailout arbitrage, further increasing the costs. This means that comprehensiveness is not enough. All countries with systemically important banks need to closely coordinate as central banks have done so far. They do not need to adopt exactly the same plan, but plans that correctly include all four measures.

In addition, as the world tips into a global recession, macroeconomic policies are urgently needed to dispel the risk of depression. Central banks have been extraordinarily active in providing liquidity. They must shift to also supporting the economy. Fiscal policy too must contribute. It may be difficult to contemplate larger deficits at a time when huge fiscal commitments must be made. Again, a prolonged recession would cost considerably more than a shorter one.

Originally published at VOXEU and reproduced here with the author’s permission.

2 Responses to "Why government responses need to be comprehensive and coordinated"

  1. JB   October 14, 2008 at 4:46 am

    Thanks Charles Wyplosz for the short summary of precise measures to be taken in order to avert a worsening of the current crisis.Could you also refer me to a source which analyzes the macroeconomic implications of the monster debt issuance currently occurring to pay for these plans? Does the current plan not exacerbate already fundamentally unsustainable levels of debt, especially in the US?

  2. Guest   October 14, 2008 at 10:42 am

    Really the fact that the US gov does not decide to take full equities as a sanction/payment, is a mystery to me. is it an ideologic brainlock, a “save my friend” behaviors, or a fear of cost ? any concrete element, proof or refutation of any hypothesis?2nd, Is’nt the US evolving toward the UK/EU style of intervention ? do you see it as nice?3rd, when you talk about fiscal incentive to avoid recession, it seems a bit too short minded, “uninque thinking”.A more deep solution might be to repair the engine, instead of simply trying to throw luggages.One of the big problem in us, cause of 30% of backrupcy, is the inefficiency of the health care system. both economically inefficient (too much energy in commerce and rejection) and medically inefficient (Emanuel Todd have pointed the same pattern of child mortality in US than in USSR earlier).If you concider that a society is a machine to product health and hapiness, clearly the engine is broken. It is not even a “social” or “moral” problem but a “material” problem as health problems cause great economic losses.Education system is also not working well. Education, like sport, is more productive when the population base is wide,. if good education is expensive, few people can aford them and talent are lost. simple statistics.There heve been “non moral” studies about efficiencies of such “commodities” like education and health… I think about the one by R Benabou in princeton. Strong math to show farmer evidence.so instead of trying to make the car lighter, by lowering taxes, why not add some weight in the form of a good turbo and a good engine, and maybe allow the driver to feel more secure with a windshield…I mean, make US more productive with a “I don’t care for your wallet, because you are US wealth” health system, and a “I don’t care of your parent wallet, because you will be my future retirement fund”.Maybe it is too late to ask chinese workers to continue buying US bonds for training US childs, and keeping US workers and families in productive state? if not yet, you should try before they get upset.moral, ethic, social is not just about pity and christian morality, but about simple social efficiency. Roman were keeping their slaves in good health, like we keep our car clean.anyway, about lightening the car, one might look about a 600Bn$ bill… look east.Military keynesianism avec been proven wrong by experience and model (forgot article). it get wrong after 6 years, according to models. but it is another story.time to INVEST in human capital.”qui veut aller loin ménage sa monture”