Bailouts: Public Money, Private Profits

Published by EH.NET (June 2010)

Robert E. Wright, editor, Bailouts: Public Money, Private Profits.? New York: Columbia University Press, 2010. vii + 147 pp. $18 (paperback), ISBN: 978-0-231-15055-2.

Reviewed for EH.NET by Andrew Jalil, Department of Economics, Reed College.

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Bailouts: Public Money, Private Profits presents a detailed study of the history of bailouts.? Divided in four chapters, the book provides a historical analysis of the issues that are at the forefront of the current policy debate on bailouts.? How should governments respond to crises?? What are the unintended consequences of bailouts?? Do bailouts speed economic recovery?? What can governments do to prevent crises?? Bailouts provides a solid introduction to these issues for non-specialists as well as a detailed historical account for experts in the field.

In the first chapter, ?Hybrid Failures and Bailouts: Social Costs, Private Profits,? Robert Wright examines the history of bailouts in the United States.? Wright notes that by privatizing profits in good times and socializing losses in bad times, bailouts can spur excessive risk taking and amplify moral hazard concerns.? Wright argues that bailouts of this nature are unwarranted and unjustified.? How then should governments respond to financial crises?? To answer this question, Wright draws lessons from the response of the U.S. government to the financial crisis of 1792.? Wright describes how Treasury Secretary Alexander Hamilton was able to successfully contain the crisis of 1792 by lending at a penalty rate to all borrowers who could post acceptable collateral.? According to Wright, by requiring that loans be made at a penalty rate and be backed by good collateral, Hamilton?s policies minimized moral hazard concerns and reduced taxpayer losses.? Wright then urges governments to adopt similar policies — that is, to adopt ?Hamilton?s Rule? — to deal with crises in the future.

In the second chapter, ?Financial Crises and Government Responses:? Lessons Learned,? Benton Gup argues that government interventions to contain crises — actions that might be necessary to prevent a major economic collapse — are sub-optimal because they address symptoms of crises, rather than direct causes.? Gup surveys scholarship on past crises and concludes that many international banking crises have been associated with the bursting of real estate bubbles.? He also identifies excess leverage, credit risk, interest rate risk, and improper securitization schemes as additional factors associated with crises.? Gup concludes that government efforts should be focused on preventing future crises and that governments need to be more proactive in responding to the conditions that generally lead to financial instability.

In the third chapter, ?The Evolution of the Reconstruction Finance Corporation as a Lender of Last Resort in the Great Depression,? Joseph Mason provides a comprehensive analysis of the history of the Reconstruction Finance Corporation (RFC), a government agency that provided emergency loans during the Great Depression.? Mason recounts how the RFC grew out of the ashes of the failed National Credit Cooperation, how the initially restrictive nature of RFC lending hindered its effectiveness in early 1932, and how the RFC became more active under the Roosevelt administration and worked with the Treasury and Federal Reserve to reorganize the nation?s banking system.? In this chapter, Mason presents a detailed description of the evolution of the Reconstruction Finance Corporation — an account that will be ideal for anyone interested in learning more about this important Great Depression-Era institution.

In the final chapter, ?After the Storm: The Long-Run Impact of Bank Bailouts,? Guillermo Rosas and Nathan Jensen present an empirical study of the effect of bank bailouts on economic recovery.? Equipped with a large international sample of banking crises, they construct a new measure of bank-bailouts — one that can be used to compare the magnitude of bank bailouts across countries.? They utilize this new measure to investigate whether larger bailouts are associated with faster economic recoveries.? They find that while larger bailouts are associated with greater fiscal costs to the state, they are not associated with more robust recoveries.? Consequently, Rosas and Jensen conclude that their empirical findings cast doubts on the effectiveness of bailouts.

However, Rosas and Jensen are cautious in formulating their conclusions due to their inability to control for the severity of banking crises or for the potential endogeneity of policy responses.? For example, it might be the case that more severe banking crises prompt governments to implement larger bank bailouts.? Under this scenario, larger bank bailouts might be associated with slow recoveries not because they were ineffective, but rather because they were implemented in the midst of more severe crises.? Rosas and Jensen are, however, candid in acknowledging this concern.? Consequently, they note that further research needs to be done to better understand the effects of bailouts on economic recovery.? Nevertheless, their study is a useful starting point and a superb resource for scholars interested in learning more about bailouts and economic recoveries.

Bailouts: Public Money, Private Profits is an excellent contribution to the literature on the history of bailouts.? By examining the issues that are at the forefront of the policy debate on bailouts, it is also a must-read for anyone interested in the policy implications of bailouts.

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Andrew Jalil is an Assistant Professor in the Department of Economics at Reed College.? His most recent paper is ?A New History of Banking Panics in the United States:? Construction and Implications.?

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