Practical analysis for investment professionals
10 January 2012

Losing Money to Preserve Capitalism: Can We Afford to Continue Bailouts? (Part 2)

A review of modern banking system bailouts demonstrates a disrespect for the capitalist philosophy of the importance of losses for preserving both capital and capitalism. In modern economic history, the need for banking system bailouts spares no continent or class of nation; G-20 nations through emerging markets all feature prominently on the list (see table below). Furthermore, from 1974 to 2009 there are only two years, 1975–1976, in which there was not a major banking system bailout taking place somewhere in the world.

On average banking system bailouts have cost nations a staggering 13% of their gross domestic product. While some bailouts cost as little as 0.1% of GDP (the U.S. bailouts of 1974 and 1984), others have cost as much as 61.9% of GDP (Turkey’s in 2000–2001). Furthermore, it typically takes 3.6 years for an economy to regain its footing after a banking system bailout. Clearly the costs of these bailouts is large and the effects long-lasting.


A Brief History of Modern Banking System Bailouts

 

Country Years Bailout as % of GDP Recovery Time in Years
Argentina 1980–1982 55.1% 4
Argentina 1995 0.5% 3
Australia 1989–1992 1.9% 1
Brazil 1994–1996 13.2% 2
Bulgaria 1996–1997 13.0% 3
Chile 1981–1983 41.2% 9
Colombia 1982–1987 5.0% 5
Cote d’Ivore 1988–1991 25.0% 3
Czech Republic 1989–1991 12.0% 1
Ecuador 1996–2000 13.0% 1
Egypt 1991–1995 0.5% 5
Finland 1991–1994 11.0% 7
France 1994–1995 0.7% 1
Ghana 1982–1989 3.0% 2
Hungary 1991–1995 10.0% 3
Indonesia 1992–1994 3.8% 9
Indonesia 1997–1999 50.0% 4
Japan 1992– 20.0% 9
Malaysia 1985–1988 4.7% 4
Malaysia 1997–2005 16.4% 4
Mexico 1994–1995 19.3% 2
New Zealand 1987–1990 1.0% 7
Norway 1987–1993 8.0% 8
Paraguay 1995–1998 5.1% 1
Philippines 1983–1987 13.2% 5
Philippines 1998–2001 0.5% 3
Poland 1992–1995 3.5% 1
Senegal 1988–1991 9.6% 1
Slovenia 1992–1994 14.6% 2
South Korea 1997–1999 26.5% 3
Spain 1977–1985 5.6% 1
Sri Lanka 1989–1993 5.0% 3
Sweden 1991–1994 4.0% 3
Thailand 1983–1987 2.0% 2
Thailand 1997–2001 32.8% 4
Turkey 1982–1985 2.5% 1
Turkey 1994 1.1% 2
Turkey 2000–2001 61.9% 2
United States 1974 0.1% 3
United States 1984 0.1% 1
United States 1989 3.4% 1
United States 2008–2009 11.5% 2
Uruguay 1981–1984 31.2% 6
Venezuela 1994–1997 22.0% 4

 

Sources: World Bank, CFA Institute, IMF, and Today’s Zaman.


While it could be argued that bailouts reduce the amount of economic pain endured by a nation’s citizens, the data seem to tell another story: bailouts tend to escalate in size over time.

For example, in the United States the modern history of the bailout began in 1974 with the rescue of Franklin National Bank. This first modern banking bailout cost $2.2 billion (in 1974 dollars) at a time when gross domestic product was $1.5 trillion (in 1974 dollars), thus totaling 0.15% of GDP. Next was the 1984 bailout of Continental Illinois National Bank and Trust Company at a cost of $5.2 billion, when GDP was $3.9 trillion, or 0.13% of GDP.

However, the costs of bailouts rose from there. In 1989 the savings and loan industry was bailed out by the United States at a cost of $188 billion, or 3.43% of total GDP. Most recently the financial crisis of 2008–2009 exacted a much heavier toll at 11.5% of GDP — or almost 77 times larger than the first U.S. banking system bailout in 1974!

If bailouts truly minimize economic pain, rather than simply forestalling it, one would expect subsequent bailouts to be smaller than the ones that preceded them. Yet, the trend of ever increasing bailouts is not unique to the United States, but borne out by the entire data series.


Escalating Costs of Bailouts

 

Bailout Number Number of Type of Bailouts Avg. Bailout as % of GDP % Change
1 34 12.0%
2 7 14.5% 21.2%
3 2 32.6% 125.2%

 


The above chart shows that of 44 modern banking system bailouts: 34 were first bailouts; 7 were a nation’s second bailout; and 2 were a nation’s third bailout. Only one nation — the United States — has had four banking system bailouts. Costs for a first bailout were, on average, 12.0% of GDP; costs for a second bailout averaged 14.5%; and costs for a third averaged 32.6% of GDP.

Further detail provides support for the idea that bailouts tend to escalate in size. Looking at the 10 bailouts from 1974–1999 that were not a nation’s first bailout, 6 of the 10 bailouts were larger than the bailout that preceded them. Yet, a strong argument could be made to include a seventh bailout to this roster. How?

In the case of the United States, its first two bailouts in 1974 and 1984 were for virtually the same size on a percent-of-GDP basis, 0.15% and 0.13% respectively. But the second bailout, because it happened ten years later, was larger by more than $3 billion on an absolute basis. It just so happened that GDP growth in the United States from 1974–1984 slightly outstripped the growth in the size of the bailout.

So a capitalist wanting to preserve the sanctity of losses for the proper functioning of capitalism could rebut the “bailouts minimize economic pain” argument by pointing out that bailouts seem to result in future bailouts of even greater size.

One possible cause for the increasing size of bailouts might be that bailouts cause damage to markets through price distortions. Most affected by price distortions are banking systems. Bailouts may violate the risk information contained within interest rates and defaults such that banking institutions take increasingly greater risks since their losses are subsidized by taxpayers.

Further damage may occur, though, to the entire economy as all participants receive a continuous stream of false prices that do not fully discount the risks present in an economy, leading to over-investment. Moreover, because of the velocity of money, and because money is fungible, the effect of this excess money is unpredictable, further distorting the economy in dynamic ways.

One further example of distortions might be the mark-to-market accounting of financial institutions that allows for tremendous leeway in the value ascribed to securities owned by financial institutions.

In conclusion, history’s great capitalist thinkers would likely be aghast at the modern history of banking system bailouts. Not only do they ignore one of the ancient and fundamental precepts of capitalism, the importance of losses, but also they seem to be escalating in size. Paradoxically, it may be that we need to lose money in order to preserve capitalism rather than simply engaging in ever more massive bailouts.


Ralph T. Byrns, PhD, Adjunct Professor Emeritus of Economics at University of North Carolina pointed me in the right direction for uncovering the ancient trajectory of capitalist thought on losses.

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: jason@jasonapollovoss.com

12 thoughts on “Losing Money to Preserve Capitalism: Can We Afford to Continue Bailouts? (Part 2)”

  1. Thanks for this very helpful summary.

    You highlight that only 1 country – the USA – has had 4 banking system bailouts and the costs have increased dramatically. That begs the question “why?”

    Could it be the corporate capture of the US political and regulatory system by Wall Street?

    Bob Monks has written about this recently http://hvrd.me/w18Obr
    And a former senior vice president of GE has outlined a practical agenda for remedial action: http://hvrd.me/xY06zI

    Is this a matter of professional concern for the CFA Institute? And if it isnt, shouldn’t it be? Investors are, by acts of commission and omission, the enablers of this situation.

  2. Hi Raj,

    The comments made in this blog post are my own.

    My own view is that this is a global societal problem, not unique to any culture as the data above shows. Further, it crosses power streams. That is, it is a problem of capitalists, but also of politics. Where these two power streams meet is certainly a natural first choice for examining this issue more closely.

    Thanks for your engagement!

    With smiles,

    Jason A. Voss, CFA

    1. Thanks Jason and for clarifying that these are your personal views. It would be great if more insiders expressed what they really thought and congratulations to your employer for allowing you to do this.

      I fully agree that the problems go beyond one country and I fear that the smugness of some EU politicians will be tested this time when the real situation about EU financial houses comes to light.

      But don’t you think there is something of a “Made in an Anglo-Saxon Capitalism-Land” label on what we are seeing, even if its now being manifested in Europe too? And equally, haven’t some countries done better at avoiding this syndrome, eg Canada, and also not rewarding the individuals who brought on the mess, eg Argentina and Iceland?

      If so, I think my question of what explains the bailouts is worth struggling with. And I would like to add to my previous hypothesis.

      Aside from the nexus of “legalised bribery” that we spoke about (I’m quoting that self-confessed “poster boy of globalisation”, Tom Friedman http://bit.ly/siuwFG), there is also the matter of how exec pay has and continues to incentivise idiotic risk taking. Put bluntly, many of the execs at the core of the banking bailouts have done very well, as Lucian Bebchuk has shown (http://hvrd.me/6Zp74V). RBS is a UK example of the same phenomenon.

      As David Cameron seems only recently to have to come to understand, these “wages for (catastrophic) failure” and the “crony capitalism” (to use the Prime Minister’s words) threaten much that we value dearly in our market-based and democratic system. If the support for that evaporates, as seems to be happening, this will be an entirely “preventable surprise”. Responsibility will rest with those who have the most power to change things today and investors are in that category.

  3. Hi Raj,

    Unfortunately, the long history of sovereign debt defaults (e.g. Willem Buiter’s “This Time Is Different”) can be traced authoritatively to at least the 1600s. Bailout history is also not a modern phenomenon and seems to be a routine historical player. Further, the intersection of economic, political and sovereign interest has usually favored the sovereign and economic forces over political. So our current situation is not so unusual.

    What this suggests to me is that it might be wise to look at how we change the human relationship to her/his wanting ‘more’ and at any cost. It is this ‘more’ motive that leads to the disproportionate corporate pay packages; consumer flirtations with excess leverage; and asset price bubbles. Short of addressing this issue I fear that we will always be dealing with the symptoms of the disease rather than the illness itself.

    This is an argument for a re-think of many things from how we educate people to how we legislate people and industry. A gigantic issue to be sure.

    Thanks, and with smiles!

    Jason

  4. Shaun W. Lockwood says:

    Bailouts are wrong for the economy. If you throw more money at bad bets its prolongs the pain and the middle class and poor are ultimately to suffer. When you throw more money at failed institutions you are destroying any productivity going forward, that money could have been put towards new infrastructure but it will take upwards of 10 years before we get back on any real growth. They think lowering interest rates to zero is helping the cause but all its doing is helping the banks receive free money basically. Also its creating housing bubble in all parts of the world. You have a lot of “free” capital racing for houses which causes the prices to speculate. Once interest rates correct to a a normalize level will will see housing prices stay stagnant for many years. The ones late to the party will ultimately pay sitting on stagnant properties for a decade.

    A good example is Japan, out of any of the examples above Japan is in closest relation to what is happening in the USA. Japan has been stagnant for 20 years. I believe USA will be stagnant for 10 years at the least. We still have many years of dead weight to get rid of, bad bets and loans to corrupt cowardly selfish leaders and CEO’s. This is essentially the problem we have with governments and central banks they think they are smarter than the natural economy, but they are far from the truth. You must let natural dynamics take its course, lets the chips fall where they may. Creating the business cycle only helps the few and destroys the many…

    1. Hi Shaun,

      Thanks for your contribution to the discussion! I agree with you that pain forestalled is not necessarily pain avoided.

      With smiles!

      Jason A. Voss, CFA

  5. Densing, Gerd says:

    If you want preventing banking-crises … you just only have following the rules of Hugh McCulloch … (Advice to Bankers of 1863) …

    Gerd Densing

    1. Hello Gerd,

      I have read those very rules courtesy of James Grant of Grants Interest Rate Observer. Thanks for pointing them out to others as their simple wisdom is timeless and unfortunately, often forgotten.

      With smiles!

      Jason A. Voss, CFA

  6. Lance Parker says:

    Jason,

    I’m commenting on your analysis in the CFA Financial Newsbrief poll that saw a 2:1 opposition to helping underwater homeowners. You posit that aversion to increasing federal debt was at the root of opposition. I, for one, oppose helping underwater homeowners because it is unfair to renters, those without mortgages, and the homeless. I strongly support fiscal expansion coupled with higher tax rates going forward to create temporary economic stimulus and long-term federal solvency. I would prefer each taxpayer receive a check for $1000 to singling out underwater homeowners (and their lenders!). Let the foreclosure process erase their debts if they desire to or must foreclose.

    Sincerely,

    Underwater Homeowner and CFA Society Member

    1. Hi Lance,

      I am certain that there are many reasons why people voted “no” to the Obama Administration’s homeowner proposals and thank you for bringing your voice from within the mass of respondants.

      With smiles,

      Jason A. Voss, CFA

  7. Mr. Voss,

    Great article. The main part that hit home was the notion that “banking institutions take increasingly greater risks since their losses are subsidized by taxpayers”. Although I am still in the process of developing my own beliefs in macro theory I believe these institutions have the utmost responsibility to its citizens to operate in a fiduciary manner. Instead it seems they use their own citizens as leverage against the government, as leaders want to avoid the economics pains of a failure at all costs, and banks abuse this relationship to take abnormal risks.

    Best,
    Slaiman Atayee
    James Madison University Class of 2015
    Finance

    1. Hello Slaiman,

      Thank you for sharing your thoughts about the piece. I am glad that it resonated with you.

      Best wishes for success!

      Jason

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