[OPE] Jayati Ghosh, "Who pays the Price for Financial Bailouts?"

Who pays the Price for Financial Bailouts?

Jayati Ghosh

Financial crises bring out all sorts of worms from
cupboards. Mostly, these reflect ineptitude, irresponsibility and
unrestrained greed, which are usually responsible for having created the
internal conditions for the crisis, even if there could be other proximate
or external factors that are associated with the crisis. But the
strategies of dealing with any crisis have to confront another huge
problem, one which could even lead to future financial crises: that of
moral hazard.

The Palgrave Dictionary of Economics defines
moral hazard as "actions of economic agents in maximising their own
utility to the detriment of others, in situations where they do not bear
the full consequences". In financial markets, these problems are
especially rife because such markets are anyway characterised by imperfect
and asymmetric information among those participating in the markets.

The moral hazard associated with any financial bailout results
from the fact that a bailout implicitly condones the earlier behaviour
that led to the crisis of a particular institution. Typically, markets are
supposed to reward "good" behaviour and punish those
participants who get it wrong. And presumably those who believe in
"free market principles" and in the unfettered operations of the
markets should also believe in its disciplining powers.

But
when the crisis hits, the shouts for bailout and immediate rescue by the
state usually come loudest from precisely those who had earlier championed
deregulation and freedom from all restriction for the markets. This has
been very marked in the current crisis hitting the US economy, reflected
in the failure of major mortgage institutions, insurance companies and
Wall Street banks.

The arguments for bailout are related
either to the domino effect - the possibility of the failure of a
particular institution leading to a general crisis of confidence attacking
the entire financial system and rendering it unviable - or to the
perception that some institutions are too large and too deeply entrenched
in the financial structure, such that too many innocent people, such as
small depositors, pensioners and the like, would be adversely affected.

It is this latter perception that has apparently led to the
recent decisions of the US Federal Reserve that have effectively bailed
out several major financial institutions in the past few months, beginning
with providing a dowry for the failing bank Bear Stearns in its shotgun
marriage with JP Morgan, and then going on to protect and then effectively
nationalise the mortgage holding agencies Freddie Mac and Fannie Mae.
Now, with the collapse of Lehmann Brothers, the looming problems of the
world's largest insurance company American International Group and as more
large Wall Street banks and finance institutions reveal the full extent of
the problems that they have accumulated in the latest housing finance
boom, the issue of more and possibly even bigger bailouts is likely to
become more pressing.

Each of these huge bailouts is being
presented as a once-off, inevitable move designed to save the system. Alan
Greenspan, the former Chairman of the US Federal Reserve, whose easy money
policies were strongly implicated in creating the speculative bubble that
has now collapsed, has stoutly defended these bailouts and suggested that
more may be necessary. In a recent interview he is said to have declared:
"This is a once-in-a-half-century, probably once-in-a-century type of
event. I think the argument has got to be that there are certain types of
institutions which are so fundamental to the functioning of the movement
of savings into real investment in an economy that on very rare occasions
- and this is one of them - it's desirable to prevent them from
liquidating in a sharply disruptive manner."

Forget, for
a moment, whether this argument is correct, or even whether it will
actually be successful in preventing a wider financial collapse. Consider
instead what sort of signal is sent to those who headed the institutions
that are being bailed out. The really great moral hazard in the financial
system today is not just related to the bailout of the institutions: it is
even stronger among those who are in charge and should be themselves
directly paying the price for taking wrong and irresponsible decisions.

Instead, financial markets are now so structured that those
running the institutions that collapse typically walk off from the debris
of the crisis not only without paying any price, but after substantially
enriching themselves further. Consider, for example, Lehmann Brothers, the
major Wall Street bank which has collapsed essentially because it went on
a completely unsustainable borrowing and lending spree, buying assets with
as little of its own money as possible and without proper due diligence or
prudential concern.

Now that the bank has collapsed, its
26,000 employees will lose their jobs, and most of them are unlikely to
find new jobs easily in the current market context. Since they held 25 per
cent of the bank's stock as employee stock options, much of their savings
is also now valueless.

But the Chief Executive Office of
Lehmann Brothers, the man who was at the helm of affairs during all the
period of its completely irresponsible behaviour, last year received a pay
packet of more than $40 million. According to the terms of his contract,
if he is terminated he will apparently receive more than $63 million as
part of his golden handshake. Since the much-publicised jail terms awarded
to some of the Enron managers in the early part of the decade, CEOs of
finance companies and banks have also grown more savvy in protecting
themselves, ensuring that the writing in their contracts provides for the
absence of any personal liability in the event of failure.
And the
compensation of those in charge in the financial sector is increasingly
divorced from any relation to the actual effects of their management.
According to a recent report in the Financial Times, compensation for
major executives of the seven largest US banks amounted to more than $95
billion over the past three years, even as the same banks recorded around
$500 billion in losses.

Clearly, therefore, the issue of moral
hazard cannot be dealt with only in terms of faceless institutions that
are being rescued with taxpayers' money. There are individuals - in fact,
a relatively small number of individuals - who were enriched by the boom,
who were able to manipulate government policies, the media and the
gullible public to ensure the creation and prolongation of what was always
a speculative bubble that would inevitably end. And these individuals also
appear to have rigged the system to ensure that they are protected from
the adverse fallout when the bubble finally bursts.

Of course,
what is happening in US capitalism today is only a repeat the pattern of
the financial crises that spread across the developing world in the 1990s
and early 2000s. In all those cases, those who were responsible for the
policies and financial actions that created the crisis, and who were the
major beneficiaries of the preceding boom, did not pay the costs of the
crises. These costs were borne by workers who lost their jobs directly
because of the crisis, as well as those who were then affected by the
stabilisation measures imposed to control the crisis, including small
businesses that collapsed because of the high interest rate-tight money
regime that is a typical post-crisis response.

Because those
responsible for the crisis do not have to pay for it, they have no
compunctions in once again creating the same conditions - and in fact that
is what is happening now in many of the formerly crisis-ridden emerging
markets.
Now it is in the US that we see how the agents of
irresponsible and predatory finance survive and even prosper as everyone
else goes under. So now the executives are laughing all the way from the
bank.

September 29 , 2008.

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Received on Sun Oct 5 16:53:45 2008