Tuesday, 30 September 2008

Expectations Bail-Out

What is a bail-out?

It’s just a promise.

A government bail-out of a private company is a promise to provide assistance such that some socially important function of the company can survive without discontinuity. The most often used form is short-term liquidity provision during bankruptcy. However, the ‘assistance’ could be provided in many other forms than mere cash (e.g., procurement orders). You, as the government, do this so that some vitally important products or services are not disrupted, or so that the reallocation of a large part of the labour force does not burden the social security system, etc. Typically, it is a systemic function provided by the private sector that you want to save.

The point here is that the bail-out is usually not immediate. It is a promise for future action. It is the promise itself that provides the stability. Frequently, the delivery is not needed or is not regarded as important when it actually takes place.

When a government offers a large pile of future cash, as in the case of the embattled Paulson Plan now, what is really promised is not the same as the number cited. It is only a “huge number”. It is managing expectations: it serves as a guarantee that the government will provide all the cash necessary to reduce the disruption to an acceptable level.

And this is the problem here.

The power to make such a promise can come from three sources.

First, the government may sit on enough cash to deliver. This is by far not the case now. None of the Western governments have much cash, especially compared to the size of their financial sectors (although there are small exceptions, like Norway). If they had, the power behind the bailout promise would come from their ability to cover the entire system. When the government offers cash on hand, it is essentially playing on expectations based on unrealistic assumptions about the ability of governments. Playing on omnipotence can get you only so far.

Second, the governments can promise future tax revenues, say by announcing that the money needed for the bailout would be borrowed first, and then the repayment needed would be raised from the tax base. However, the indebtedness of most western governments is substantial. That of the US is so large that it would not be able to get membership in the Eurozone. Thus raising the kind of money needed to fully back the financial sector would be impossible. Furthermore, what would be the source of new loans in a global financial crisis? From whom would you get that kind of money?

Finally, and most importantly, a future tax-revenue-based bail out in the magnitude of the annual GDP is unrealistic, to be euphemistic. (One year of US GDP could cover only around one-fourth of the US financial sector, and then the global linkages have not come in yet). You cannot promise to save the entire economy from collapse by promising money that you will collect in the future from the same entity. Thus the implicit promise of a full government guarantee, plays on the assumption that only a partial guarantee will really be needed.

Which leads to the third source of power:

The power of the bail-out promise could come from the government’s singular ability to change the rules. This reads something like this: “I do not have enough money to buy you out. And I cannot possibly promise to raise enough money from you in the future to buy you out now. But I could promise to change the rules under which you operate. Then I could claim that you will be in better condition in the future. If you do believe this then, arguably, you will be in a better condition. Then I can promise to raise taxes from the healthy-you in the future, and thus I can even promise to back you up with money now…”

This argument is entirely based on the assumption that there is a way to change the rules such that the current chaos is sorted out, and not repeated in the future. Hence all the sudden talk of socialism. That would change the rules, that is for sure. Some people might even believe in it. But you would need a mass change in the way western societies view themselves for such an expectations-bail out to work.


All of these expectations are based on a framework of thinking which is rapidly going out of date. Since 16 September we have been re-evaluating what is possible.

Which brings us to the ultimate question: can the US government, or any government, credibly promise to deliver systemic solutions now? Doesn’t this crisis, which is still in its early days, reveal that there is a need to replace the national level economy-management toolbox with global policy institutions? Could any local solution be a remedy even for the short term?

1 comment:

  1. Monday's OA conference call about the crisis. There was quite a bit about expectations and the bail-out plan. It is a bit long, but if you feel like suffering, the link to the audio file is here.