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.