A bailout is defined as a rescue of an economic unit from actual or potential insolvency, performed by a separate economic entity. In a bailout, a rescuer intervenes in an economic quagmire that is too drastic that the entity which requires a bailout cannot wait for the market forces to correct themselves and return back to equilibrium . In general, either a rescued or a rescuer can be a company, an individual, an international organization or a government. In most cases of bailouts, central banks and national governments are rescuers of domestic financial entities. Another common case is rescuing of governments by international financial organizations like the IMF and the World Bank . This assistance is based on the membership in these international organizations.
Countries that have to participate in bailout activities take part in high risk investments which are coupled with poor decision making. With investors undertaking increasingly risky business ventures with the hope of making great returns on investment, banks and other financial institutions are inclined towards financing some of these projects through loans . The provision of these loans could be due to the viability of a project or due to credit worthiness of these investors. However, most of these financial institutions fail to offer guidance and inspection of the investors’ operations with the aim of safeguarding against financial loss arising from mismanagement of funds or even bad decision-making . This negligence does not help in the reduction of chances of failure of these projects, and so bailouts are not the optimum solution to insolvent companies.
Banks are a source of credit for businesses. When they lend a lot of their money to businesses and there are no returns, there is a strain to respond to the demand side and provide credit to consumers in the economy. When it becomes difficult for businesses to acquire funding, they are unable to take part in economic activities. These activities include expanding lines of products, hiring of human resource, research and development and market expansion.
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These activities are the major source of income to consumers. When consumers cannot access credit or get a regular source of income through salaries and wages, they lack the power to purchase goods and services as they do not have money to spend. This becomes a cyclical problem, as both the consumer and business sides support each other. If the financial needs of one are not met, the other one cannot effectively operate. The impact is directly felt by the other party. This is when the rescuer comes in and tries to apply corrective measures to change the scenario. Usually, the first step is the mitigation of the effects of such imbalance, and then recovery efforts are instigated. Later on measures are put in place to prevent a slide back into the financial crisis. This is mostly an expensive venture in which taxpayers’ money is directed.
Rescuers have employed the use of an array of bailout policies, the most common of these policies being an issuance of direct loans or issuance of guarantees of third-party loans to an entity that needs a bailout. These loans are usually designed to be in favor of the financially troubled entity. The rescued entity may also receive direct subsidies from the rescuer. Another method would involve a purchase of newly issued shares by the government, mostly preferred stock, from an entity that requires a bailout . This, however, may come with several stringent conditions including a change in management, all of or some dividends, restrictions on the pay-in effect for executives for a given amount of time pending recovery or payment of the amount issued by the government. In addition to that, there may be imposed relaxation of guidelines and regulations that may govern the behavior and accounting in the rescued entity over a period of time until recovery. This adds up to government interference with the market, disallowing market forces to operate freely.
For banks, there are more options in policies to be adopted for bailouts. Government guarantees that exist can be expanded to higher amounts. Sometimes these amounts are unlimited. These guarantees may be created where they do not exist to facilitate a bailout . It is important to add that bad securities or loans of financial entities can be obtained either by a quasi-government agency or by the government itself at rates higher than the prevailing market prices, with the government taking over the responsibility to dispose of the bad debts or securities .
Arguments for Bailouts
To start with, a bailout ensures that the rescued entity does not collapse in a situation where the financial climate is temporarily unfavorable. This can be important in saving many jobs that could be lost due to the collapse of the institution. Jobs provide income to the government through income tax and by extension taxes on commodities and services rendered. The government would also avoid the consequences that come with high unemployment rates in regard to the economy. With consumers having purchasing power, the government stands a better chance of growing its tax base . In addition to that, the government will safeguard another source of revenue in company taxes from going down. The effects of this can be felt after the complete recovery of the institution.
Secondly, governments can stem a breakdown of the financial system of the country. This can be done by putting in place policies to save operational commercial banks from collapsing. The government uses the ‘Too Big to Fail’ policy. This policy stipulates that the government shall not let institutions that are important either in size or operational capacity to collapse . Mostly, the government assessment of these institutions gives a conclusion that they are important to valued sectors in the economy, or are essential for the survival or good performance of the entire economy.
Bailouts offer a ‘safety net’ from where the economy can begin its recovery. In the maintenance or creation of a productive GDP after a financial depression faced by the economy, the government needs to ensure the survival of industries. The US government bailed out General Motors, a company operating in the automobile industry. This move was important as the government was successful in efforts to create a starting point from which the US economy could be built. The bailout of banks and industries in the United States ensured that the government remained operational and that the economy continued to operate during the hard economic times. The government continued to get revenue to fund its operation even in the thick of the harsh economic climate.
Government intervention to bail out entities gives the citizenry a sense of security. Most banking systems are understood to be corrupt and therefore actively participate in malpractices for selfish gains . The fact that the government is the lender of last resort gives the public the feeling that no misuse of public funds will take place. Managers of banks and other financial institutions have the reputation of awarding themselves huge bonuses even when their companies are collapsing. This was avoided in the case of the US government bailout of industrial firms and financial institutions.
Bailouts also avert the loss of public faith in financial institutions, in particular, investors. In addition to the financial systems being revamped to become stronger and more stable even in the face of economic turmoil, the public sees the efforts that financial institutions put in to avoid a systematic collapse. In the absence of bailouts, the public and foreign investors would lose trust in the ability of the financial institutions to handle their demands for deposits and loans . In so doing, there would be a significant inactivity in the financial sector. This inactivity would translate to less economic activities in the economy, leading to an economy that is not developing at the rate at which it should. Other economies could even stop growing, or worse, deteriorate further.
Bailouts have also proven to push global market forces towards Pareto equilibrium. This is in regard to bailouts by international financial institutions like the IMF and the World Bank. The anticipation by member countries that they would receive funding activates operations geared towards trading activities and investments by both local and international players. This pushes the global market towards Pareto optimal performance . In case there was lack of intervention by global financial institutions, the domestic markets would operate on stringent conditions that would stifle economic growth rates. The prospect of bailouts by such financial establishments encourages lending by investors to member countries in excess amounts, with the interest rates being put at levels that are not indicative of the risks involved. Borrowers are also encouraged to be less prudent in their behavior .
Arguments against Bailouts
Anticipated bailouts appear to advocate for complacency. There is also an adoption of moral-hazard behavior by rescued entities. Entities that participate in economic transactions with the rescued entity like customers, depositors, borrowers and lenders also take up moral-hazard behavior . Rescued entities engage in economic activities that are highly risky in nature and become too large. In regard to banks, there is an increased desire to invest in high risk ventures that put a lot of strain on the finances of the institution with the knowledge that a bailout would be forthcoming in case of a failure.
When governments anticipate funding from the IMF, the World Bank or other global financial institutions for bailout purposes, it is assumed that they will use the funds in the best interests of the public; therefore the governments would be able to undertake projects that would be inclined towards benefitting the public. This scenario cannot, however, be replicated in situations where the government has to bail out institutions. These institutions cannot guarantee actions convergent with the needs of the public. If these rescued firms adopt moral-hazard behavior, yet public funds have been put into the bailout, there is a high probability that the funds would be used badly, leading to loss of money.
Another demerit is that it is not obvious that a bailout will be successful. A bailout is a temporary intervention. In the event that there is a repeat failure by an institution in the future, there would be a need to repeat the intervention and rescue the entity . If indeed a bailout turns out to be successful, there would still be chances that inefficiencies may arise to have an effect on the improvements made by the bailout. A government may bail out an entity in turmoil because it assumes that the bailout is temporary and the company has an ability to perform well and support itself in the near future. The market, however, may not share the same view . The market performance is determined by numerous external and internal factors that may work against the institution even after pumping public funds into an entity as bailout. This is very similar to infant-industry tariffs, which have proven that government failure is mostly created while market failure is subject to forces in the market.
Finally, in case a government performs its part in the process of a bailout, there is no certainty as to whether the rescued entity will play its part. For instance, banks may hoard funds instead of lending them out to the public even after the government has provided capital funding for banks facing economic turbulence.
Bailouts are also seen as a way of rewarding bad decisions . After a crisis has been created by players in the financial and other relevant sectors, the government may come in and offer a solution by issuing more money, regardless of whether these companies found themselves in a bad situation because of poor decision making. This is a recipe for another round of financial impropriety by a company or others who share the same status. The managements would not give emphasis to addressing the underlying issues in the matters causing poor performance. Rather, they would be offered stimulus packages that they may subject to the same misuse as before.
Despite the fact that bailouts are considered to have saved the day in many cases such as that of the United States, some analysts have reservations about the efficacy of bailouts, to prove that bailouts are not the best way to use when dealing with failed entities. Many experts believe that government intervention is not a permanent solution, and that it is a way of rewarding complacency and poor decision making. A liberalist position is that an action has to be taken in order to save corporations from collapsing. Other analysts have, however, expressed valid fears regarding excess government influence on the economy and markets, poor oversight of financial management by executives and continued poor mismanagement of institutions and funds .
Despite this criticism, economists have defended the bailouts by governments and financial institutions saying they are a necessary measure to stem economic failure and stop the economy from spiraling down towards collapse and restore confidence and faith in economic systems. With this in mind, recommendations have come abound for the use of alternative methods of dealing with financial crisis other than bailouts, which are more effective and less costly to taxpayers.
First, seeking an alternative to a bailout would mean avoiding intervention by the government to allow the market to operate freely. One way of doing this would be to facilitate the absorption of weak or mismanaged institutions by larger, more established and stronger firms. Instead of providing funds to banks in bailouts, a government can allow its Central Bank to liquidate solvent banks, leaving aside insolvent banks. This action would allow the weakest banks to fail.
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In the event of the government’s failure to intervene, economic agents would be allowed to face the results of their actions, thus not generating moral hazard. In addition to that, it prevents the exposure of public funds to risk. Furthermore, the sector of the economy that a firm, which is not rescued, operates in would be strengthened through mergers with other companies or even takeovers. The result would be consistent with what the market needs, as long as the government does not intervene in the merger through bailout policies.
Secondly, it would be prudent to take up macroeconomic policies. Currency depreciation and inflation are viable methods that have been successful in many similar scenarios. Debtors can be relieved, considering that macroeconomic policies are not discriminative. In a crisis that affects the entire system; general macroeconomic regulations should be activated before any bailout is attempted.
The third way would be to allow the non-rescued entity to continue existing, yet lose autonomy to certain levels. This bears the advantage of giving the firm some time to recuperate from bankruptcy protection. In addition to this, tax payers do not incur any costs in saving such a firm. In this regard, it is clear that bailouts are not the best way to save companies from collapsing, as they do not give assurance of success as compared to alternative methods discussed in this document.