Sunday, July 17, 2011

Bailouts are for buying time, disclosure is for restoring functioning capital markets

The Telegraph ran a column asking the question of whether more bailouts is really the right solution for the European sovereign debt crisis.

This is a trick question because everyone knows that all bailouts do is buy time.  By themselves, bailouts do not solve any problems.

For example, putting more capital into large US banks did not cause the losses on their toxic security holdings or second mortgages to go away - that was achieved through suspension of mark-to-market accounting and adoption of extend and pretend regulatory forbearance.  In theory, bankers could have realized their losses using the bailout capital.  In practice, bankers preferred to return the bailout funds and resume paying themselves large bonuses even though the losses still remain on their bank balance sheets.

The real question is how is that time purchased by the bailout going to be used to cure the underlying intertwined problems of sovereign debt and bank solvency.

Your humble blogger has proposed using that time to implement disclosure under the FDR Framework to restore functioning capital markets.
In the light of the deepening eurozone crisis and concerns over the implications of the EU bank stress tests, many commentators are now saying that the EU sovereign debt bailout fund needs to be perhaps five times as big, and that governments must declare themselves willing to recapitalise any insolvent or capital-inadequate banks as soon as next week. 
Really? You really think that the lesson of the past four years, since the financial crisis began in mid-2007, has been that governments have just not been sufficiently willing to stand behind the banks? That the problem with the eurozone is that governments that aren’t broke haven’t been willing to lend enough to those that are? That the poor impoverished bondholders in banks and sovereign debt have just been exposed to totally unreasonable levels of credit risk? 
... But surely anyone can see now that this has been a Failed Strategy  Surely anyone can see that the answer, from here, just can’t be for governments to become even more committed to their banking sectors, and bank bondholders even more shielded from any risk of loss? Surely anyone can see that the answer can’t be to move banking sector losses from poorer governments’ balance sheets onto richer governments’? Someone has to be left that isn’t broke! 
... This is a Failed Strategy. I understand perfectly well the political attractions of Denial, that governments in 2007 and 2008 wanted to pretend that nothing was really wrong, that it was all evil speculators or irrationally pessimistic markets, and if they could just bluff it out then the markets would understand that they’d got it wrong. Even if markets had been wrong (and they do get these things wrong sometimes), I wouldn’t have agreed that the government should pursue Denial – were governments truly in a position of such omniscience that they could declare, arrogantly, that the markets were wrong? And was the cost – the destruction of Private Capitalism, a system in which capital was allocated through private banks with depositors and bondholders subject to risk of loss - really worth it? In practice the government’s strategy was immoral – involving bailing out the richest 20 percent of the population (those with large deposits, those with large pension pots invested in the banking sector) at the expense of taxing the poor. 
Since I regarded the strategy as arrogant, destructive of our economic order (Private Capitalism) and immoral, I would have objected to it even if it had “worked” in its own terms.  But it didn’t.  Surely – surely – it’s time to try something else?

No comments: