Making Creditors Suffer

Tyler Cowen, co-author of a prominent independent economics blog, has an article in The New York Times explaining “Why Creditors Should Suffer, Too.”

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals [for financial regulation], the government is effectively neutralizing creditors as a force for financial safety.

I couldn’t agree more (except for the bit about the regulatory proposals, and that’s just because I haven’t read them closely). We need creditors who will pull their money or demand tougher terms from financial institutions that are doing things that are either too risky or just plain stupid; that’s theoretically a more efficient and cheaper enforcement mechanism than regulatory bodies.

Cowen also has an accurate read of the current situation:

This poses a very difficult public relations problem for the government, because the Federal Reserve and the Treasury do not want to discuss the importance of the creditors too publicly right now.

Why not? It would be bad precedent, and mind-bogglingly expensive, to promise to pick up all future obligations to major creditors. At the same time, any remarks that threaten to leave creditors hanging could panic the markets. So silence reigns.

Or, there’s an implicit expectation that creditors of large financial institutions will be protected, but that expectation periodically wears off and has to be bolstered by some confidence-boosting measure, but that measure can never be an explicit guarantee . . . and so on.

Cowen has some suggestions for how to fix this problem in future regulation. But what should we do right now? As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.


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

5 Responses to "Making Creditors Suffer"

  1. Hyperflation man   April 5, 2009 at 9:50 pm

    Government should have more tax on creditors, like taxing on executive bonus, who get the benefits of AIG reckless actions. AIG bailout is intentionally the way to turn the loss of private investors into the loss of public that is unacceptable.Now the loss of US government is increasing everyday and that will cause the higher cost of living of people from the higher government debts and higher tax on taxpayers, not higher tax on private investors. Therefore, I do not understand why taxpayers should pay higher tax to support loss of private investors.One thing we have seen is the lower welfare of country. Now government will create higher budget deficit and will create higher uncertainty of deficit from unknown loss of bailout. FED has also intervened market by printing money and definitely will create loss from intervention and uncertainty of amount of money expansion in the future.From the uncertainty of loss of intervention and size of government deficit and size of money printing, the medium-to-long term bond yield is at the highest risk of losses from government new supply from higher deficit and the higher risk of hyperinflation of money printing. If government debt is uncontrolled and FED has to monetize debts more aggressively, the 3% 10-year bond yield is not reflecting the future hyperinflation and new supply of debts. We could not see the sharp increase in inflation in this or next year but we have the higher uncertainty and higher risk of hyperinflation and new bond supply. The medium-to-long term bond yield should move upto 5-10% and is volatile to reflect the uncertainty.The higher bond yield and uncertainty will create the uncertainty of economic policy and definitely deter the private investment and consumption from the higher risk premium compensation. That will create the long deterioration of growth. We could end up only the stagflation (there is some growth but low) or the depression with hyperinflation (no growth but price will increase sharply because in the long run there is no relationship of price and economic growth)

  2. Guest   April 6, 2009 at 6:59 am

    Geithner, Summers et al have drunk the free-market deregulatory Kool-Aid, and are being compensated, professionally (and monetarily, in Summers case), for it. They have no interest in remaking the system that has given them power; they want to rehabilitate it. That means working with bond cronies PIMCO and Blackrock, feeding the hedgies, and bailing out our zombie banks for as long as it takes, using as much money as it takes.The self-dealing and corruption running between the Street and DC stinks to high heaven. But no one in power has any interest in changing a thing.

  3. Guest   April 6, 2009 at 8:54 am

    “So silence reigns.” Amen, amen, amen. “As long as the ongoing, ever-changing bank bailout leaves existing entities (a) under current ownership and (b) out of bankruptcy court, no force on earth can make the creditors suffer without their consent. So either we need to accept that creditors get a free pass this time, or we need to relax one of those constraints.” Hallelujiah, hallelujiah, hallelujiah.Obamanomics. Don’t rock the wall street boat, let insiders zombie the economy along (Larry Summers, Geithnar), and keep quite about the taxpayer fleecing.