How Large Will the Next Bailout Be?

It seems that large bailouts are becoming the norm these days. TARP was 700 Billion, the recent agreement to support European governments is larger than $1 Trillion. Are these reasonable numbers? How large will the next one be?

There is still some confusion about what these bailouts do. In their design, they deal with a situation of financial distress that some see as a problem of liquidity (short-term financing) but others see as a problem of solvency (the business or the government will never be able to generate enough funds to pay for the current debt). Policy makers are uncertain about whether liquidity or solvency is the true problem but they might see reasons under both scenarios to still go for the bailout. If it is liquidity, the reasons are clear, you do not want a large institution, a large government or the whole financial system collapse and drag others into financial distress. In the case of solvency, it is less obvious but there are still economic (or political) reasons to keep some companies or governments alive (as in the case of the car industry in the US).

If liquidity is the real problem, the cost to taxpayers should be minimal or one could even imagine a profit from the lending. If solvency is the problem, there will have to be a transfer from taxpayers to the company or government in trouble.

In the case of TARP, the plan to buy toxic assets in the US, there was always an understanding that some of the purchases would constitute a transfer to the financial institutions holding those assets but there was a lot of uncertainty about its financial amount. Today’s estimates are more optimistic than some of the earlier ones with a total cost somewhere around $90 billion.

In the case of Greece, we are talking about loans that do not imply a direct transfer to the Greek government. It could, of course, be that the interest rate charged to the Greek government is seen as below market and this could be considered a transfer — but if the final goal is achieved and the Greek government does not default, then the market interest rates were simply overestimating the true risk and there is no transfer implied in the interest rate set by the loans. If Greece defaults and this default affects the bonds purchased by this rescue plan then there is a cost to the taxpayer.

The reaction of financial markets (both the stock and bond market) to the plan is difficult to understand. The plan does not involve a direct transfer to the Greek government (or any of the other European governments that might need the funds). If the reaction was so positive it must either mean that the market believes that this was a liquidity problem that was just solved or the market reads more into the plan than what you see in the statement by the ECOFIN. Maybe they see the promise of a future transfer if liquidity problems turn into insolvency for the Greek government.

My interpretation is that a direct transfer (not a loan) to the Greek government from other European countries is unlikely to happen. So the $1 Trillion plan looks more like a way to send a strong message (a number that was much higher than what most expected) and, at the same time, ensure liquidity over the months to come. It seems that the number matters more to the markets than the details. In practice, not much has changed. The government of Greece still needs to find the necessary revenues (taxes) to cover their spending and service the debt. They have bought themselves some time but the fundamental imbalance remains and it needs to be addressed.

There will be other crisis and I wonder if this is a trend of designing larger and larger bailouts to make sure that they provide the necessary reassurance to financial markets.

And if you want to look at the less serious side of bailouts, you can always play the bailout game (click on the image below).

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About Antonio Fatás 136 Articles

Affiliation: INSEAD

Antonio Fatás is professor of Economics at INSEAD. He is a Research Fellow at the Centre for Economic and Policy Research in London and has worked as external consultant for international organizations such as the International Monetary Fund, the OECD and the World Bank.

He teaches the macroeconomics core course in the MBA program as well as different modules on the global macroeconomic environment in Executive Education. His research is focused on the study of business cycles, fiscal policy and the economics of European integration. His articles appear in academic journals such as the Quarterly Journal of Economics, Journal of Monetary Economics, Journal of Money, Credit and Banking, Journal of Public Economics, Journal of International Economics, Journal of Economic Growth, European Economic Review or Economic Policy.

Professor Fatás earned his M.A. and Ph.D. from Harvard University, and M.S. from Universidad de Valencia.

Visit: INSEAD

Be the first to comment

Leave a Reply

Your email address will not be published.


*

This site uses Akismet to reduce spam. Learn how your comment data is processed.