Having rejected Henry Paulson’s rescue plan, it’s
not clear what Congress—or those in the broad population
opposed to a “bailout”—propose to do to
keep the financial system from imploding. But a database of systemic
banking crises recently assembled by IMF economists Luc Laevan and
Fabian Valencia ( www.imf.org/external/pubs/cat/longres.cfm?sk=22345.0  )
provides a useful map of how crises play out and what does and
doesn’t work.

Laevan and Valencia identify 124 systemic banking crises between 1970
and 2007, and assemble detailed information on 42 of them, representing
37 countries. (Some countries, like Argentina, appear multiple times.)

In almost every case, governments took active measures to mitigate the
crisis, so there is no real test of whether rescue schemes actually
work; no politician seems willing to face the consequences of letting
the chips fall where they may. But the work of Laevan and Valencia does
offer some guidance as to what works best.

Dithering Costs
One crucial lesson stands out: speed matters. This is obvious to anyone
who followed Japan’s dithering in the 1990s; standing aside
and hoping the problem goes away is not a good idea. Relatedly,
“forbearance”—regulatory indulgence, such
as permitting insolvent banks to continue in business—does
not work, as has been established in earlier research. As the authors
say, “The typical result of forbearance is a deeper hole in
the net worth of banks, crippling tax burdens to finance bank bailouts,
and even more severe credit supply contraction and economic decline
than would have occurred in the absence of forbearance.” This
suggests that suspending mark-to-market requirements is not a good idea.

Since forbearance does not work, some sort of systemic restructuring is
a key component of almost every banking crisis, meaning forced
closures, mergers, and nationalizations. Shareholders frequently lose
money in systemic restructuring, often lots of it, and are even forced
to inject fresh capital. The creation of asset management companies to
handle distressed assets is a frequent feature of restructurings, but
they do not appear to be terribly successful. More successful are
recapitalizations using public money (which can often be partly or even
fully recouped through privatization after the crisis passes); recaps
seem to result in smaller hits to GDP. But they’re not cheap:
they average 6% of GDP, which for the U.S. would be about $850 billion.

Total fiscal costs, net of eventual asset recoveries, average 13% of
GDP (over $1.8 trillion for the U.S.); the average recovery of public
outlays is around 18% of the gross outlay.

But those who don’t want to spend that kind of taxpayer money
should consider this: Laevan and Valencia find that “[t]here
appears to be a negative correlation between output losses and fiscal
costs, suggesting that the cost of a crisis is paid either through
fiscal costs or larger output losses.” And if the economy
goes into the tank, government revenues take a big hit, so
what’s saved on the expenditure side could well be lost on
the revenue side.

Oh, and about half the countries that have experienced crises have had
some form of deposit insurance. So merely expanding the
FDIC’s coverage is not likely to do the trick—and,
in any case, it’s going to be hard to escape the huge expense
of a systemic recapitalization, though using the FDIC might simplify
the politics of the rescue.

(A note on the politics of the rescue: an ABC poll shows the public to
be far more worried about the economic consequences of the
bailout’s defeat than Congress seems to be. There’s
not a lot of enthusiasm for what’s seen as handing money over
to Wall Street—but if properly structured and sold, say with
more cost recovery prospects for the government, more relief for
debtors, a rescue is not as unpopular as some would have it.)

Relevant Examples
Most of the countries in the Laevan/Valencia database are in the
developing world, and are of questionable relevance to the U.S. But TLR
has taken a closer look at four countries that offer more relevant
models: Japan, Korea, Norway, and Sweden. Some major stats for the four and the U.S. are in the table at the end of this entry, as are  graphs of some important indicators.

Sweden, now widely seen as a model of swift, bold action, kept its
ultimate fiscal costs relatively low—3.6% of GDP at first,
almost all of which was recovered through stock and asset
sales—but was unable to avoid a deep recession. At the other
end of the spectrum, Japan, the model of foot-dragging half-measures,
saved no money through its procrastination; its fiscal outlay was 24%
of GDP, almost none of which was recovered. And it was unable to avoid
recession.

Note, though, that some of the worried talk surrounding the financial
market impact of bank bailouts looks misplaced, at least on these
models. Three years after the outbreak of crisis, inflation was lower
and stock prices higher in all four countries, and government bond
yields were lower in all but Japan. It’s likely that the
deflationary effects of a credit crunch outweigh the inflationary
effects of debt finance.

Although the U.S. in 2007 had a lot in common with other countries on
the brink of a banking crisis, one thing stands out: the depth of the
current account deficit. Of the four comparison countries, only Korea
comes close to the U.S. level of red ink. The unweighted average
current account deficit of the 42 countries in the Laevan/Valencia
database was 3.9% of GDP—compared with 6.2% for the U.S. That
suggests that the U.S. has more to deal with than just resolving a
banking crisis.

A Better Bailout
So, with the modified Paulson plan dead for now, what might a better
bailout scheme look like in light of the Laevan/Valencia historical
database?

First, it must be adopted quickly. Perhaps operating through the FDIC
would be a way to accomplish that, though the FDIC will almost
certainly need to have its coffers copiously refilled.

Second, forbearance would be a bad idea; it does no one any good not to
face reality.

Third, purchasing bad assets and turning them over to an asset
management corporation is not a promising strategy.

Fourth, recapitalizing the banks should be the heart of any policy; as
the authors say, it should be selective, meaning supporting those
institutions with hope of revival, and letting the terminal go down.

And fifth, targeted relief for distressed debtors, supported with
public funds, has also shown success in earlier banking crises, and
should be part of any rescue scheme in the U.S. as well.
Crises like this are manageable. They’re expensive and
painful to resolve, but even more expensive and painful when left to
fester.

—Philippa Dunne & Doug Henwood

All percentage figures except inflation, GDP growth, bond yields, stock prices, and employment are percent of GDP. Gross fiscal cost is total outlays for banking system support; net is after equity and asset sales. Output loss is total deviation from trend growth rate in GDP from the crisis year through three years after crisis onset, expressed as a percent of trend GDP. Minimum growth is the lowest level of GDP growth reached during the crisis. Pre-crisis stats are for the year before the onset of the crisis. Recap costs are costs of cash, equity, or debt injections or asset purchases to recapitalize the banking system; net is after recovery of these costs through asset sales and the like. Stats labeled “three years later” are changes in indicators three years after crisis onset. “Gov bonds” are bond yields reported by the IMF in its International Financial Statistics database. “Stocks” are the based on the stock indexes published in IFS. Stats in the first eleven rows come from “Systemic Banking Crises: A New Database,” by Luc Laeven and Fabian Valencia (IMF Working Paper 08/224) and the associated spreadsheets available from www.imf.org/external/pubs/cat/longres.cfm?sk=22345.0

. The next four rows are computed by TLR from the IFS database.

The economy of the next few years could well make the long stagnation of the early 1990s look like a boom. Although as recently as last year pundits were brushing off concerns about the savings rate, it would be a lot easier to float the proposed $700 billion if our savings rate were 8% instead of 0%.  The restructuring of our financial landscape will have to be accomplished at the same time as the wrenching shift away from debt-supported consumption as the driving force of our economy, and, as we have stressed many times, restoring economic growth and competitiveness will require higher levels of public and private investment. This all makes it especially galling to contemplate spending $700 billion in an attempt to salvage the debts racked-up in yesterday’s unproductive housing/consumption boom. In fact, the economic effect of this bailout is pretty much the same as dumping the money into the deep blue sea.

Much commentary has focused on what the proposed $700 billion bailout will mean for the U.S. fiscal situation and the bond market. Though clearly federal finances would be a lot better if the government weren’t going to spend all that money, it does look like the government can handle the borrowing, and the bond market might even rally over the longer term (after taking an initial hit). We’ve got lots of problems, but the debt itself is probably manageable.

The two graphs below show the U.S. government’s budget balance and total debt outstanding, both expressed relative to GDP. Note that if you add the assumed $700 billion cost of the bailout (4.9% of GDP) to the likely 2008 federal deficit (2.9% of GDP), you get a total deficit of 7.8% of GDP. This is quite large by recent standards; the highest it got in the 1980s was 6.0% in 1983. It’s nothing next to the World War II deficits, which maxed out at 30.3% of GDP in 1943, but that was a special case, to put it mildly.

Debt levels, though, look a lot more modest. Total debt held by the public is around 37.9% of GDP this year; adding 4.9% to that takes us to 42.8%, well below the recent high of 49.4% in 1993. The gross debt figures are higher, mainly because of the large amounts of Treasury paper being accumulated by the Social Security system. That might be a problem someday, but not for at least a decade or two.

As for the bond market, the only thing approaching a precedent we have for that is the Resolution Trust Corporation, which bought up the bad debts of the S&Ls. It was created in August 1989—almost a year before the cyclical peak.  As the graph below shows, yields on the 10-year rose over the next year, and then began a long decline, as the credit crunch and economic stagnation took hold.

Between the cyclical peak in interest rates in September 1990 and the credit crunch low in October 1993, the real total return on bonds was 88% (price plus yield deflated by the CPI). Of course, rates were much higher in those days; the yield on the 10-year was 8.89% in September 1990, for example. So it’s not likely we’ll see a real total return so high in the coming years. But it does suggest that worries about an inflationary spike in interest rates may be overdone. And debt levels were considerably higher in those days: they rose from 40.6% of GDP in 1989 to 49.4% in 1993—in other words, the starting point in 1989 was only 2 points below the projected effects of a $700 billion/4.9% of GDP bailout.

We’ve got a lot of challenges ahead, but we should be clear on exactly what they are.

—Philippa Dunne & Doug Henwood

With the presidential election a mere 127 days from the release of this
report, and the candidates apparently not waiting for the
once-traditional Labor Day kickoff, this is a good time to look at the
partisan patterns in some major economic and financial indicators. The
differences are significant, and worth thinking about for anyone with
dollars at stake after January 20, 2009.

Not to spoil the suspense too much, but here are the basic
conclusions. Since Franklin Roosevelt’s third term (1941–44),
Democrats have generally presided over faster growth and stronger stock
markets than Republicans; Republican administrations have been
friendlier for disinflation and the bond market. Also, Republicans tend
to preside over recessions early in their terms, with growth
accelerating as time passes; Democrats tend to preside over earlier
accelerations followed by slowdowns as the term matures.

Originally published January 12, 2007

There ain’t no seat-belt hefty enough to keep you in your seat if you decide to take positions based on evidence in
the Monthly Treasury Statements. 

Every couple of months, an analyst seizes on a fluctuation, often a wild fluctuation,
in the Monthly Treasury Statements to make the case that the job market is either far stronger or way weaker
than the Bureau of Labor Statistics’ estimates suggest. Oh, OK, these remarks do come disproportionately
form those on the hunt for evidence that the Bureau of Labor Statistics is underestimating payrolls, witness recent attention to January’s surge in withholding at the federal level, recent stories focused on another strong showing in March receipts, and the fact that once the “hidden strength” story is out in the markets for a given month, the almost inevitable reversal in the following month never makes it to traders’ screens.