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|
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|
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.