Which is right, the British bailout approach or the American Paulson Plan?

Let’s set some context. The U.S. and Britain (as well as Ireland, Germany, Spain, the Netherlands, Belgium and Iceland) now display the recurring patterns of governments using public credit to offset the losses of financial firms in the name of financial and social stability. Why do these bailouts occur? Should they be done and, if so, how?

This debate is not new. It goes back at least to 1802, when Henry Thornton (The Nature and Effects of the Paper Credit of Great Britain) clearly discussed the “moral hazard” and “systemic risk,” as we now call them, involved. At the end of the last really big U.S. bust, in 1989-91, Americans were relieved to have the government “resolve” things by presenting the bill for the cost of its deposit guarantees to the taxpayers. The Nordic countries, the Japanese and others in the 1990s had big bailouts. And here we are again.

How can we understand why this happens? Financial systems involve a fundamental contradiction. At its heart is the political desire to make short-term assets, especially deposits, effectively riskless. But these deposits fund businesses which are inherently quite risky, highly leveraged and cyclically subject to losses greater than anyone ever imagines possible–just as we are now experiencing. The combination of riskless funding with risky businesses is in fact impossible. Governments are therefore periodically put in the position of desperately wanting to transfer losses from the banks to the public–as once again today.

These transfers effectively make the taxpayers into involuntary equity investors. How do we give them fair treatment as investors?

Congress has just enacted the $700 billion Paulson Plan. But this plan does not recognize that what is actually happening is involuntary equity investing. The British capital injection plan is honest about making this explicit.

A model of the explicit capital injection approach from U.S. history is the Reconstruction Finance Corporation (RFC) of the 1930s. This was one of the most powerful of the agencies created to cope with the greatest U.S. financial crisis ever. The underlying logic is this: When financial losses have been so great as to run through bank capital, so that no one knows who is broke and who isn’t, when waiting and hoping have not succeeded, when uncertainty and risk premia are extreme–what the firms involved need is not more debt, but more equity capital.

This is the typical pattern of governments faced with a financial crisis. First, there is delay in recognizing losses while issuing assurances (e.g. “the subprime problems are contained”). Then there is the central bank as liquidity provider or lender of last resort, lending freely but providing by definition short-term debt, not equity. But when the capital is gone, something different is needed–an emergency provider of new equity capital.

Created by the Hoover administration and expanded by the New Deal, the RFC’s investments in American companies, mostly financial institutions, totaled $50 billion. Adjusted for the change in the Consumer Price Index since 1933, this is about $800 billion–but adjusted for the growth in nominal gross domestic product, it would be about $12 trillion.

The most important element of RFC operations to address the nationwide financial collapse was its ability to invest in equity capital in the form of preferred stock, the same as the current British plan. More than 6,000 financial institutions, including many of the principal banks of the day, were the recipients of RFC investments.

The basic RFC approach was described by its head, Jesse Jones, in his instructive memoirs, Fifty Billion Dollars: My Thirteen Years With the RFC. It consisted of four principal steps:

1. Write down the troubled assets to realistic economic values and consequently write off book equity.

2. Make a judgment about the character and capacity of management and make any appropriate changes.

3. Based on realistic asset values and capable management, have the RFC buy new equity in the bank in the form of redeemable, dividend-paying preferred stock.

4. Receive dividends and, ultimately, the par value of the preferred stock back as the bank returns to profitability and recapitalizes in the private market over time.

In fact, this proved to be a successful crisis model. On the RFC model, the taxpayers, instead of merely providing subsidies, make equity investments that have an expected return. Indeed, one important improvement on the RFC model should be that the public deserves greater equity upside potential. The government’s preferred stock should be combined with warrants on the common shares of the recapitalized firms, as in Chrysler bailout, which resulted in significant profit to the government. This structure might provide attractive outcomes for the taxpayer-investors, as the crisis passes and growth in time resumes. Any profit, if achieved, should be earmarked as dividends to the taxpayers in return for their investment. Such dividends might be in the form of specific tax credits.

Many financial crises can be bridged by provision of central bank liquidity, such as those of the Greenspan era. But the worst cases involve severe asset deflation and destruction of financial system capital. They need something different: the emergency provision of new equity as a bridge to private recapitalization when normal financial functioning is restored–the British, rather than the Paulson Plan–approach.

Congress and the Treasury should be putting a crisis equity investing operation, with any profits earmarked as dividends for the taxpayer-investors, in gear now.