To bailout or not to bailout
Macroeconomics Spring 2011
It seems simple to talk about banks during the current financial crisis, as it has been receiving the most attention; therefore, this will be the discussion of this paper. But what exactly is a bailout? “A bailout occurs when a higher level of government assumes obligations of a lower level of one in the face of the latter’s inability or unwillingness to meet these obligations.” Some, from a policy standpoint, feel it does become appropriate, both in Europe and in the United States, for the government to intervene and save banks from collapsing? “On June 26th the Spanish government announced details of a rescue fund of up to €99 billion ($137.7 billion) to help the country’s banks weather a severe storm of bad loans and help restructure its bloated banking system.” How did this work out? “So far Spain’s banks have held up well, thanks to cautious regulation and a focus on traditional banking.” There have been some bankers who have come forward and offered what some might consider a confession. “Looking back now, I must confess that while my banker panelist may not have been making his point effectively, he did have a point.” On the other side of the Atlantic, the US has its own issues with government involvement with bailing out banks. “Fannie and Freddie, you’ll recall, were government-sponsored agencies created to support the growth of the American housing market.” The main argument put forth in this paper, that despite all the personal bankruptcy files stacking up on the desks, it is in the interest of federal governments to have private banks accept responsibility for making irresponsible lending to individuals, or firms who clearly would be unable to pay back loans of considerable amounts. To that end, this paper will discuss the repercussions of a bailout, how it can be managed, and future dilemmas posed if a bailout occur, such as in the case with Fannie Mae and Freddie Mac. “The issue with Fannie and Freddie was that as private firms with shareholders to please the businesses sought to maximize profits, while at the same time their quasi-governmental status led markets to conclude that the companies were supported by an implicit government guarantee.” Each section will detail the pro’s and con’s of each decisions made by policymakers. The level of risk that was taken in handing out large sums of money for homes or businesses must be scrutinized and evaluated as continued lending in this manner will allow for further debt to increase, and burdens increase in weight all around – both personal and corporate.
Bailing out a lender, bank or credit union, who failed to properly check and secure a realizable payback system in place is a criminal offense and should be treated as one in a federal court, though this can be difficult to do if the federal government has taken responsibility for regulating. One case in Mexico is a prime example. “Even if the higher-level government knows perfectly well that the lower-level government caused its own financial distress, by irresponsible behavior, it may be willing to provide a bailout for many reasons: for example, because the central government cares about the welfare of its citizens …” This then becomes both a moral and legal issue. “IT WAS a year ago that the European Union produced its big bazooka to quell the euro area’s sovereign-debt crisis: a €750 billion fund to safeguard the single currency, following within days of the €110 billion bail-out of Greece. It did not work. Ireland has since been bailed out, and a rescue of Portugal is in the works. Greece looks closer than ever to defaulting, or at least to having its debt restructured.” This is referred to as “predatory lending” where the rich (banks) entice the vulnerable (poor, or average) into taking out large sums of money at an interest rate they fail to understand the payback method and if they can actually afford to do so. What happens is a domino effect, until banks run out of money to hand out to individuals, or businesses that actually can pay back the amount borrowed, thus crowding out the pool of money available. One example is in the US, where “We called the AIG deal a bail-out, and worried that it created moral hazard, because the government paid AIG’s creditors in full. You can’t have a bail-out unless somebody gets bailed out.” Occurring is a process whereby the average citizen gets caught in a trap of owing more than what they thought they would have to pay back, plus the interest rate. Meanwhile, the banks enjoy collecting this money until the individual becomes unable to return it due to purchases made outside the budget constraints from the loan – often this is the case when the loan process is taking place – such things other then what the money was intended for, such as luxury items that are not really needed or agreed upon during the agreement process.
Bailing out is bad
Imagine for a moment that you are feeling entitled to own a home and you enter a financial institution, and the individual notices your anxiety to own and fails to review past credit standing and the ability to pay off, based off of financial records such as current salary, or salaries. This individual – loan officer – after poring over documents goes ahead and proceeds with handing out large sums of money to the family or individual receiving the loan. At this point it becomes important to identify who is at fault for handing out the large sum of money – the loan officer or the borrower – both knowing that it is nearly impossible to payback and the amount, plus the interest. Compound this situation over thousands and millions of families or firms, and we are presented with a mass situation where banks are presented with a decision to make: appeal to the federal government for assistance (money) in order to keep lending. At this point, we reach a critical policy decisions: to bailout or not to bailout. If the federal governments opt to bailout, this allows for continued borrowing to take place, and the situation continues to repeat its self, and the government debt continues and it prints more money allowing for “predatory lending” too keep taking place without any form of punishment taking place. The question then is asked, what should the correct form of punishment be when “loan sharks” lazily hand out large sums of money to those they do know have no method to payback the amount plus the interest added to it. Or, for policy makers, when should, if at all, the government intervene. “The state must maintain “positive” market incentives that reward economic success. When the government is tempted to take away too much income and wealth generated by future success, individuals have no incentives to take risks and make effort today. I am not sure there is a correct policy decision here to; it seems difficult to know what should happen to those handing out, and the leaders of those institutions, as well as those hiring loan officers, as well, so this doesn’t continue to occur. Sending individuals to prison is also quite difficult and a policy should be made so this does not happen again, to that end prison sentence just allows individuals remain alive, and with the possibility of parole, or release.
Now if we consider the opposite, if the banks are not bailed out, what happens – or an austerity measure – is implemented instead of government intervention? This then forces those who took the money to find other means in order to pay back the loans, or in other words, work harder and cut back on spending on certain unnecessary, or non essential items. In economic terms, we refer to luxury items: expensive cars, boats, homes, etc. Unfortunately, the borrower is now required to conserve, rather than spend so that they have the ability to pay back so the banks to do not have to be bailed out. The willingness to do so, is a key factor in this process, which will be the subject of the next section; what exactly can be done so that banks do not need to appeal for a bailout.
Problem is in the process
How exactly do the banks arrive at the decision to hand out a loan for cars, homes, and/or businesses to individuals or firms? Which documents do they review before handing over a piece of paper binding people or peoples to a certain amount of money? Credit history documents, current salary information, and an inventory of certain items already in possession might also be important, so the loan officer might be able to have some insight on what exactly the individual or firm might have an incentive to spend that money on, rather than what was agreed upon in the contract, because in essence this is free money and once the documents have been signed and the credit card has been issued, or money transferred they are technically able to spend it on whichever they choose, generally without any monitoring. The Japanese model offers interesting insight into the banks role in lending. “Many firms in Japan have very close ties to a ‘main bank’. The bank provides debt financing to the firms, owns some equity, and may even place bank executives in top management positions.” It appears that not only the lower end lenders, but upper management as well must be held accountable for the money it gives out.
Monthly or quarterly statements arrive in the mail, or email inboxes stating the amount that shows proof of what the money has been spent on. These usually are confidential and are not discussed with the financial institutions, just the amount that is owed. This is where the dilemma lies, can the amount be paid. If not, the amount becomes compounded and the amount grows. If it can be, the amount is paid and the agreement becomes stable. At what point does the loan officer step in and intervene to the individual or firm when payments cannot be made? At what point – one year or one month – does the phone ring or an email sent stating they are behind on their payments and the money is taken away and are left with debt and find organizations collecting valuables from them in order to cover the cost of the back payments of the loans, potentially leading to homelessness. This then begs the question, is a policy of government intervention, or bailout, such a bad thing. They hold the power to print money and circulate it throughout the economy; however, if this continues, so does the debt.
If we view debt, especially in large amounts, as a negative utility, financial institutions, such as banks and credit unions, need to enforce greater measures to ensure that, call it more detailed monitoring, to ensure the loan money is being properly spent on what was agreed upon in the contract. This may mean a shift in economic policy, to enact a daily reporting tool of what the monies was spent on. Reporting more accurately what the loan money was spent on so that accountability from both parties can be kept abreast of how the money is being spent, so the government does not need to intervene, and can keep the financial institutions more accountable for the money they have already been given. Failure to implement this type of policy will allow continued abuse of money and power between individuals as well as banks and credit unions lending money to people who are incapable of paying back the amounts they originally signed up for. This policy, like all policies, is not perfect and does have a flaw. This would require another position besides the loan officer, or “shark”, but rather someone who has the ability to monitor the expenses in a more detailed fashion. For the sake of the argument, we’ll call this the loan monitor, one with the authority to check detailed expenditures from the pool of money lent from the financial institution, and should be enclosed in part of the agreement, a new type of agreement document that the individual is fully aware that their expenses are now going to be closely monitored in the future, which is the topic of the next section.
What happens if a new position, such as a loan monitor is implemented? Some have argued that if banks are bailed out there is a moral element at play here. “When there is a commitment to bail out before the market forms expectations about the exchange rate and make desciision about effort and investment, we find the following results: First, the private sector will enforce lower effort than in the case when there are no commitments to bailing out.”
This has the potential for borrowers to have some sort of fear that their expenses will be accounted for in a more detailed manner, and thus will have an incentive not to deviate from the agreement that took place within the walls of the financial institution of their choosing. By deviating – spending on unnecessary things (luxury items) – will be closely scrutinized and allow for the borrowers to stay on track and purchase what was intended to in the documentation. If this is not done, the ability for borrowers and lenders to lose track of how money is spent, could be catastrophic, which is what we see currently in both Europe (Greece and Portugal) and the United States of America (Bank of America). What happens when both parties lose track is when we see a domino effect of bankruptcy on both continents.
Where does this all stop? For some, this can be viewed as a breach of privacy (if a personal monitor is enacted) for watching over how ever dollar or euro is spent; however, for policymakers it becomes imperative, and could be painful, to allow financial institutions to create positions that will allow greater transparency into how that money is being spent so the system does not fail, as what we have seen currently in the world today; however, blame cannot be placed solely institution, but at the personal level as well. Those unable to calculate how much they will be required to pay on a monthly, or quarterly basis, should not be entering the doors of these places where free money is given away, but should be required to pass a basic math class before signing any agreement that will bind them to that same institution. This needed to be a sophisticated, or difficult math class, but one where the ability to calculate an interest rate over X number of years and how much that will cost them given their current state of salary, or salaries as a combined income. Once a certificate showing proof that they can also calculate the interest rate over X number of years, then a loan can begin to be processed and maybe distributed to that family or firm. Until that point, walking through the doors would be a mistake at the individual level. This is because bailing out is a two-way process. Also, for the future, accurate record keeping should be done in the home and in the institution so that proof of purchasing the money and how it is being spent can be protected for checking. This can be done both in paper and electronically. I am inclined to suggest storing this electronically, after it has been scanned in and stored safely in a server somewhere in both places, the firm/family home and the financial institution.
Once these files have been set up, a text message or email should be the form of communication transfer of how this money is being spent, preferably on a weekly basis when servers are updated. This will allow both parties to keep accurate results of how that money is being spent, and possibly a reduction in the interest rate as payments are met on time, this creates an incentive to spend the money they way it was agreed upon. This has a positive externality, as individuals and firms both have an incentive not to deviate, and thus are rewarded and not punished for improper use of the free funds handed out. The reputation is also imperative, both for the bank/credit union and individual and it is much more likely that that financial institution will attract more clients, resulting in less of a need for government intervention. As the reputation grows, more and more clients will continue to use that financial institution over others and create less of a demand for money from the central bank (government) so that the government can choose to spend money on other important sectors of the economy, such as health, education and defense. Failure to adequately check on the borrowers spending habits can result in future failures for banks and a continued downward spiral of inflation and the government printing money, on the contrary, if implemented it has the potential for banks to regain their reputation as a source the general population can turn to in order to improve their livelihood.
This paper has put forth the argument that bailing out banks is not a recommended policy, but rather a reevaluation of the internal process in financial institutions produces a better outcome and a better future through a greater reputation for the population. Furthermore, any loan that is to be administered from a loan officer must accompany a math class with a certificate stating the individual or firm is fully aware of the costs associated with borrowing money from that financial institution. This is because bailing out both parties is at fault: the firm/individual and the banks/credit unions. Rather than point the finger and say this is wrong, both parties need to take a look at the way they value money, or wealth. If feeling entitled to have luxuries items, without the necessary math skills required to pay back debt, which population is at fault? Failure to sufficiently check the individual’s background and realize whether this is even possible for them to pay it back is an even greater crime, though the punishment is the variable that escapes policymakers on how best to regulate this. Many CEOs have received jail sentences, even life, but should we, as taxpayers pay to keep them alive. I would argue yes, since we may too make the mistake in thinking we could pay off those debts. Since we are concerned with public policies, a recommendation would be a special position such as a loan monitor to be created so that tracking the expenses more closely so personal abuse does not occur, and banks too can be made aware how their funds are truly being spent. Until this policy is in place, and banks are continued to be bailed out, the government will continue to print money and prices will rise, and debts will soar.