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 A bailout is an act of giving capital to a company in danger of failing in an attempt to save it from bankruptcy, insolvency, or total liquidation and ruin; or to allow a failing company to fail gracefully without spreading contagion.


A bailout could be done for mere profit, as when a predatory investor resurrects a foundering company by buying its shares at fire-sale prices; for social improvement, as when, hypothetically speaking, a wealthy philanthropist reinvents an unprofitable fast food company into a non-profit food distribution network; or the bailout of a company might be seen as a necessity in order to prevent greater, socioeconomic failures: For example, the US government assumes transportation to be the backbone of America's general economic fluency, which maintains the nation's geopolitical power. As such, it is the policy of the US government to protect the biggest American companies responsible for transportation—airliners, petrol companies, etc—from failure through subsidies and low-interest loans. These companies, among others, are deemed "too big to fail" because their goods and services are considered by the government to be constant universal necessities in maintaining the nation's welfare and often, indirectly, its security.

Emergency-type government bailouts can be controversial. Debates raged in 2008 over if and how to bailout the failing auto industry in the United States. Those against it, like pro-free market radio personality Hugh Hewitt, saw this bailout as an unacceptable passing-of-the-buck to taxpayers. He denounced any bailout for the Big Three, arguing that mismanagement caused the companies to fail, and they now deserve to be dismantled organically by the free-market forces so that entrepreneurs may arise from the ashes; that the bailout signals lower business standards for giant companies by incentivizing risk, creating moral hazard through the assurance of safety nets (that others will pay for) that ought not be, but unfortunately are, considered in business equations; and that a bailout promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout. Others, such as economist Jeffrey Sachs have characterized this particular bailout as a necessary evil and have argued that the probable incompetence in management of the car companies is insufficient reason to let them fail completely and risk disturbing the (current) delicate economic state of the United States, since up to three million jobs rest on the solvency of the Big Three and things are bleak enough as it is. In any case, the bones of contention here can be generalized to represent the issues at large, namely the virtues of private enterprise versus those of central planning, and the dangers of a free market's volatility versus the those of socialist bureaucracy.

Furthermore, government bailouts are criticized as corporate welfare which encourages corporate irresponsibility.

Governments around the world have bailed out their nations' businesses with some frequency since the early 20th century. In general, the needs of the entity/entities bailed out are subordinate to the needs of the state.

Themes from bailouts

From the many bailouts over the course of the 20th century, certain principles and lessons have emerged that are consistent:
  • Central banks provide loans to help the system cope with liquidity concerns, where banks are unable or unwilling to provide loans to businesses or individuals. Lending into illiquidity, but not insolvency, was articulated at least as early as 1873, in Lombard Street, A Description of the Money Market, by Walter Bagehot.
  • Let insolvent institutions (i.e., those with insufficient funds to pay their short-term obligations or those with more debt than assets) fail in an orderly way.
  • Understand the true financial position of key financial institutions, through audits or other means. Ensure the extent of losses and quality of assets are known and reported by the institutions.
  • Banks that are deemed healthy enough (or important enough) to survive require recapitalization, which involves the government providing funds to the bank in exchange for preferred stock, which receives a cash dividend over time.
  • If taking over an institution due to insolvency, take effective control through the board or new management, cancel the common stock equity (i.e., existing shareholders lose their investment), but protect the debt holders and suppliers.
  • Government should take an ownership (equity or stock) interest to the extent taxpayer assistance is provided, so that taxpayers can benefit later. In other words, the government becomes the owner and can later obtain funds by issuing new common stock shares to the public when the nationalized institution is later privatized.
  • A special government entity is created to administer the program, such as the Resolution Trust Corporation.
  • Prohibit dividend payments, to ensure taxpayer money are used for loans and strengthening the bank, rather than payments to investors.
  • Interest rate cuts, to lower lending rates and stimulate the economy.


Reasons against bailouts

  • Signals lower business standards for giant companies by incentivizing risk
  • Creates moral hazard through the assurance of safety nets
  • Promotes centralized bureaucracy by allowing government powers to choose the terms of the bailout
  • Increases government control over businesses.
  • Instills a corporatist style of government in which businesses use the state's power to forcibly extract money from taxpayers.


Paul Volcker, chairman of Barack Obama's White House Economic Recovery Advisory Board, said that bailouts create moral hazard: they signal to the firms that they can take reckless risks, and if the risks are realized, taxpayers pay the losses, also in the future. "The danger is the spread of moral hazard could make the next crisis much bigger".

On November 24, 2008, American Republican Congressman Ron Paul (R-TX) wrote, "In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones. How this is supposed to be good for our economy is beyond me.... It won’t work. It can’t work... It is obvious to most Americans that we need to reject corporate cronyism, and allow the natural regulations and incentives of the free market to pick the winners and losers in our economy, not the whims of bureaucrats and politicians."

Bailout costs

In 2002, World Bank reported that country bailouts cost an average of 14% of GDP.

Cases

Irish banking rescue

In 2008 Irish banks suffered substantial share price falls due to a lack of liquidity in finance available to them on the international financial markets. Currently, solvency is being revealed as the most serious concern as doubtful loans to property developers, still undeclared in bad debt provisions, come into focus.

Swedish banking rescue

During 1991–1992, a housing bubble in Swedenmarker deflated, resulting in a severe credit crunch and widespread bank insolvency. The causes were similar to those of the subprime mortgage crisis of 2007–2008. In response, the government took the following actions:

  • Sweden's government assumed bad bank debts, but banks had to write down losses and issue an ownership interest (common stock) to the government. Shareholders were typically wiped out, but bondholder were protected.
  • When distressed assets were later sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies in public offering.
  • The government announced the state would guarantee all bank deposits and creditors of the nation’s 114 banks.
  • Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral.


This bailout initially cost about 4% of Sweden's GDP, later lowered to between 0–2% of GDP depending on various assumptions due to the value of stock later sold when the nationalized banks were privatized.

U.S. Savings and Loan Crisis – 1989

In response to widespread bank insolvency as a result of the Savings and Loan crisis, the United States established the Resolution Trust Corporation (RTC) in 1989.

Other bailouts



See also



References

  1. Definition of a bailout from a business dictionary
  2. Too Big to Fail?
  3. A Bridge for the Carmakers
  4. Mason-Lessons from Bailouts Part 2
  5. Lessons from Japan Bailout
  6. IMF Paper
  7. Time Magazine - Lessons from Japan & Asia
  8. NYT-Lessons from Japan
  9. Blodgett History of Bailouts
  10. Volcker Criticizes Obama Plan on ‘Systemically Important’ Firms Bloomberg, 2009-09-24
  11. The Bailout Surge, by Ron Paul, 11-24-2008
  12. Cost of bailouts
  13. "Behind the Bailout" — NOW on PBS


Further reading



External links




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