As the US economy is hit by the financial crisis and associated bailout costs, it is useful to take an international perspective on current events. In the last three decades, many countries in the developing world have also experienced financial crises and large bailouts. Yet, the growth gains brought by financial liberalization and deregulation have, in most cases, far more than offset the output and bailout costs of crises. Importantly, financial liberalization by itself did not generate crises: government meddling and implicit bailout guarantees were often involved. In many ways, the US story is not that different.
In the current debate, pundits are railing against the enormity and unfairness of the US bailout, not to mention the bad precedent it will set. Many also point to financial deregulation as a key cause of the crisis. But the facts suggest otherwise. First, the size of the bailout is within historical and international norms. Second, financial liberalization and deregulation policies along with financial innovation have largely contributed to the impressive growth performance of the US economy relatively to European Union countries. The development of new financial instruments has helped finance the IT revolution and the large-scale increase in home ownership. Both factors have been powerful engines of US growth. Third, policy interventions, such as the effort by some in the administration and Congress to induce Fannie Mae and Freddie Mac to move into the subprime mortgage market, have largely paved the road to the financial crisis the US faces today.
How big is the current US bailout compared to other bailouts? The $700bn bailout bill is equivalent to 5% of GDP. Adding to it the cost of other rescues –Bear Stearns, Freddie Mac and Fannie Mae, AIG– the total bailout costs could go up to $1,400bn, which is around 10% of GDP. In contrast, Mexico incurred 18% of GDP in bailout costs following the 1994 Tequila crisis. In the aftermath of the 1997-98 Asian crisis the bailout tag was 18% of GDP in Thailand and a whopping 27% in South Korea. Somewhat lower costs, although of the same order of magnitude, were incurred by the Scandinavian countries in the banking crises on the late 1980s: 11% in Finland (1991), 8% in Norway (1987) and 4% in Sweden (1990). Lastly, the 1980s savings and loans debacle in the US had a cumulative fiscal cost for the taxpayer of 2.6% of GDP.
The bailout costs that the taxpayers are facing today can be seen as an ex-post payback for years of easy access to finance in the US economy. The implicit bailout guarantees against systemic crises have supported a high growth path for the economy –albeit a risky one. In effect, the guarantees act as an investment subsidy that leads investors to (1) lend more and (2) at cheaper interest rates. This results in greater investment and growth in financially constrained sectors –such as housing, small businesses, internet infrastructure, and so on. Investors are willing to do so because they know that if a systemic crisis were to take place, the government will make sure they get repaid (at least partially).
Importantly, there must be systemic insolvency risk for the bailout scheme to have these effects. This is because a bailout is not granted if an isolated default occurs, but only if a systemic crisis hits, since only under the threat of generalized bankruptcies and a financial meltdown would Congress agree a bailout. Thus, an investor will be willing to take on insolvency risk only if many others do the same. When a majority of investors load on insolvency risk, they feel safe (because of the bailout guarantee). No wonder many financial firms end up with huge leverage and loaded with risky assets. In the Tequila and Asian crises the risky bet was the so-called currency mismatch, in which banks fund themselves in dollars and lend in domestic currency. In the US it took the form of toxic mortgage-related assets. No innocent souls here. Borrowers, intermediaries, investors and regulators understood the bargain. At the end, the bailout guarantee scheme has succeeded in inducing more investment by financially constrained agents in real estate and small businesses.
Perhaps the financial sector lent excessively, leading to overinvestment in the housing sector today, and the IT sector in the late 1990s. But the bottom line remains that risk-taking has positive consequence in the long run even if it implies that crises will happen from time to time. Over history the countries that have experienced –rare– crises are the ones that have grown faster. In those countries, investors and businesses take on more risks and as a result have greater investment and growth. Compare Thailand’s high-but-jumpy growth path with India’s slow-but-steady growth path before it implemented liberalization a few years ago. Over the last 25 years, Thailand grew 32% more than India in terms of per-capita income despite a major financial crisis. Similarly, easier access to finance and risk-taking explains, in part, why the US economy has strongly outperformed those of France and Germany in the last decades.
Some argue for the rolling back of financial liberalization and for a return of the good old days of strict regulation. Not so fast! Today’s bailout price seems high. But is it that much relative to the higher growth the US has enjoyed in specific sectors and overall? Let’s wait for the final price tag. Other countries’ experience tells us that financial liberalization –and some of its consequences– ain’t such a bad idea after all. They also teach us the importance of jump starting quickly the lending engine so as to avoid a growth collapse, and for the regulatory agencies to refrain from killing the natural risk-taking process that accompanies the resumption of credit growth.