If the financial system stabilises, the US economy would benefit by 2-3% in terms of avoiding lost output.
The question now is: what is the cost of the alternative to the “bailout”, that is, do nothing and let financial institutions around the world collapse like dominoes? What would the cost be of that?
The visible costs of these serial “bailouts” are estimated at over $1 trillion. But this adds apples and oranges. There is a difference between: (a) liquidity being provided by the Federal Reserve (which does not cost taxpayers a dime) to lubricate seized-up credit markets, and (b) funds being sought by the US Treasury, not for public expenditure but for the purchase of a stock of securities (collateralised by mortgages on houses whose prices are collapsing but will recover some years from now) issued by investment banks. It has been done before quite successfully (thrice in the US and more recently in Sweden and Japan). So what is all the fuss about?
At the end of the day what is likely to happen is that the Troubled Asset Relief Programme (TARP) will use $700 billion to buy out about $2 trillion (in face value) of toxic securitised assets that have no meaningful market price right now. That would immediately create additional “capital headroom” of about $160-200 billion for the banks, allowing for an 8-10 per cent capital adequacy requirement. It may result in a further $40-50 billion being written back in capital. The big unknown is whether that will be enough. Present estimates of the amount of recapitalisation required for the global financial system range from $500 billion to $1 trillion. It is difficult to see where that capital is going to come from when the share prices of financial firms are so depressed, and sovereign wealth funds are gun-shy.
The benchmark established by Merrill Lynch a few months ago when it sold a bundle of the toxic securities was 22 cents per dollar of face value. That is regarded (by the Fed chairman, among others) as a “fire sale” price. Allowing for a 35-50 per cent premium over that price, one would expect most reverse auctions (unless they are rigged) to result in a price of around $0.30 to $0.33 per dollar. Held to maturity, or stripped down, unbundled, and reconfigured over time it would not be unreasonable to expect these assets to be disposed of at prices of between $0.60 and $0.75 on the dollar when normalcy returns, house prices stop plummeting, and mortgage delinquencies decline.
Assuming (quite reasonably) that this happens, the US Treasury stands to recover between $1.2 trillion and $1.6 trillion (if not more), for an outlay of $700 billion. Discounting for the time value of money, that is a return of 20-35 per cent on $700 billion. So where is the bail-out? If the financial system is stabilised as a result of this measure (a big “if”, supposing that banks can be recapitalised sufficiently quickly) and credit starts flowing normally again, the net immediate benefit to the US economy could be up to 2-3 per cent of GDP or about $300-400 billion in avoiding lost output.
How much more government oversight and regulation are needed? Much has been said about the failure of regulation being as responsible for this crisis as the failure of financial markets, banks and bankers. Some of it is right. But it is not clear that more regulation would have avoided the problem. The risk is that more of the wrong kind of regulation might worsen the situation by impeding the normal flow of credit because of exaggerated concerns about risk and regulatory micro-management of financial firms. Real market and regulatory failure occurred in the US, which has among the most rule-based regulatory regimes in the world. Its central bank is the prime regulator. It is a system which is the most fragmented, with mortgage lending and insurance being regulated at state rather than federal level, resulting in repeated failures. It is not clear whether the alternatives (greater oversight, more regulation, and so on) would necessarily have achieved much better outcomes.
Much has also been said about the failure of regulation in the UK, where regulation was unified and separated from the central bank. But Northern Rock was not a failure of regulation as much as it was a failure of judgement on the part of the key human actors involved. It showed up the dangers of appointing academics to positions that should be occupied by people with practical knowledge of how markets actually work and how financial firms react in a crisis. The contrast between the intellectual dithering of the top level UK authorities and the US Fed with each turn of the screw, and the decisive, pragmatic responses of the US Treasury Secretary (an experienced market operator), could not be more stark.
The real arguments about regulation for the future are yet to come. Many of the actions taken will be aimed at fighting the last war, not the next one. The best option is to ensure that the incentives for self-regulation are designed to work better than they did, and that financial system regulation is unified and not fragmented. It is also better for regulation and supervision to be separated from a monetary authority to avoid cascading conflicts-of-interest and cloud central bank judgement about its previous errors.
What about “socialising profit” and “privatising cost”? The present crisis has brought out the stark problems of privatising profit only for the eventual costs of market failure to be socialised. If TARP works, that prospect will be reversed. But in the final analysis these questions and arguments are hollow. In as extreme a crisis as this, when confidence in the financial industry is lost, the only option left is to deploy heavy artillery involving the credit of the state. That is because the state is only instrumentality that can legitimately print money to meet its obligations. But, like nuclear weapons, that option is best used as a deterrent in extremism, rather than one which is invoked regularly. When that happens, the public begins to believe that finance is an area in which markets either do not work, or create so much systemic and social risk, that the credit and authority of the state should underpin the credibility of the financial system at all times, and not just in extraordinary ones.
The author chaired the high-powered committee on making Mumbai an international financial centre
