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If the financial system stabilises, the US economy would benefit by 2-3% in term

s of avoiding lost output.


The question now is: what is the cost of the alternative to the bailout , that is,
do nothing and let financial institutions around the world collapse like dominoe
s? What would the cost be of that?
The visible costs of these serial bailouts are estimated at over $1 trillion. But
this adds apples and oranges. There is a difference between: (a) liquidity being
provided by the Federal Reserve (which does not cost taxpayers a dime) to lubri
cate seized-up credit markets, and (b) funds being sought by the US Treasury, no
t for public expenditure but for the purchase of a stock of securities (collater
alised by mortgages on houses whose prices are collapsing but will recover some
years from now) issued by investment banks. It has been done before quite succes
sfully (thrice in the US and more recently in Sweden and Japan). So what is all
the fuss about?
At the end of the day what is likely to happen is that the Troubled Asset Relief
Programme (TARP) will use $700 billion to buy out about $2 trillion (in face va
lue) of toxic securitised assets that have no meaningful market price right now.
That would immediately create additional capital headroom of about $160-200 billi
on for the banks, allowing for an 8-10 per cent capital adequacy requirement. It
may result in a further $40-50 billion being written back in capital. The big u
nknown is whether that will be enough. Present estimates of the amount of recapi
talisation required for the global financial system range from $500 billion to $
1 trillion. It is difficult to see where that capital is going to come from when
the share prices of financial firms are so depressed, and sovereign wealth fund
s are gun-shy.
The benchmark established by Merrill Lynch a few months ago when it sold a bundl
e of the toxic securities was 22 cents per dollar of face value. That is regarde
d (by the Fed chairman, among others) as a fire sale price. Allowing for a 35-50 p
er cent premium over that price, one would expect most reverse auctions (unless
they are rigged) to result in a price of around $0.30 to $0.33 per dollar. Held
to maturity, or stripped down, unbundled, and reconfigured over time it would no
t be unreasonable to expect these assets to be disposed of at prices of between
$0.60 and $0.75 on the dollar when normalcy returns, house prices stop plummetin
g, and mortgage delinquencies decline.
Assuming (quite reasonably) that this happens, the US Treasury stands to recover
between $1.2 trillion and $1.6 trillion (if not more), for an outlay of $700 bi
llion. Discounting for the time value of money, that is a return of 20-35 per ce
nt on $700 billion. So where is the bail-out? If the financial system is stabili
sed as a result of this measure (a big if , supposing that banks can be recapitalis
ed sufficiently quickly) and credit starts flowing normally again, the net immed
iate benefit to the US economy could be up to 2-3 per cent of GDP or about $300400 billion in avoiding lost output.
How much more government oversight and regulation are needed? Much has been said
about the failure of regulation being as responsible for this crisis as the fai
lure of financial markets, banks and bankers. Some of it is right. But it is not
clear that more regulation would have avoided the problem. The risk is that mor
e of the wrong kind of regulation might worsen the situation by impeding the nor
mal flow of credit because of exaggerated concerns about risk and regulatory mic
ro-management of financial firms. Real market and regulatory failure occurred in
the US, which has among the most rule-based regulatory regimes in the world. It
s central bank is the prime regulator. It is a system which is the most fragment
ed, with mortgage lending and insurance being regulated at state rather than fed
eral level, resulting in repeated failures. It is not clear whether the alternat
ives (greater oversight, more regulation, and so on) would necessarily have achi
eved much better outcomes.

Much has also been said about the failure of regulation in the UK, where regulat
ion was unified and separated from the central bank. But Northern Rock was not a
failure of regulation as much as it was a failure of judgement on the part of t
he key human actors involved. It showed up the dangers of appointing academics t
o positions that should be occupied by people with practical knowledge of how ma
rkets actually work and how financial firms react in a crisis. The contrast betw
een the intellectual dithering of the top level UK authorities and the US Fed wi
th each turn of the screw, and the decisive, pragmatic responses of the US Treas
ury Secretary (an experienced market operator), could not be more stark.
The real arguments about regulation for the future are yet to come. Many of the
actions taken will be aimed at fighting the last war, not the next one. The best
option is to ensure that the incentives for self-regulation are designed to wor
k better than they did, and that financial system regulation is unified and not
fragmented. It is also better for regulation and supervision to be separated fro
m a monetary authority to avoid cascading conflicts-of-interest and cloud centra
l bank judgement about its previous errors.
What about socialising profit and privatising cost ? The present crisis has brought o
ut the stark problems of privatising profit only for the eventual costs of marke
t failure to be socialised. If TARP works, that prospect will be reversed. But i
n the final analysis these questions and arguments are hollow. In as extreme a c
risis as this, when confidence in the financial industry is lost, the only optio
n left is to deploy heavy artillery involving the credit of the state. That is b
ecause the state is only instrumentality that can legitimately print money to me
et its obligations. But, like nuclear weapons, that option is best used as a det
errent in extremism, rather than one which is invoked regularly. When that happe
ns, the public begins to believe that finance is an area in which markets either
do not work, or create so much systemic and social risk, that the credit and au
thority of the state should underpin the credibility of the financial system at
all times, and not just in extraordinary ones.

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