Sudip Bandyopadhyay’s Blog

Last week’s dramatic events hold two transatlantic lessons in opposite directions, one from Europe to the US and one the other way.  The first comes from Sweden, which suffered its own financial crisis during the early 1990s.  The Swedish lesson is that bank bail-outs should be handled conservatively and should come in the form of direct capital injections.  As in the US, the Swedish financial crisis was also preceded by a property bubble, which was pricked by a rise in real interest rates.  Severe stress in the financial system and the economy were to follow.  In each of the three years 1991, 1992 and 1993 Swedish gross domestic product fell in real terms, at an accumulated rate of about 5 per cent.  In response, the Swedish government set up an agency to recapitalize the financial sector.  Bank shareholders were not compensated.  But the Swedish government did not bail out all banks, only a subset.  They used a microeconomic model to determine which of the banks had a chance to survive, and which did not.  Those that did not were liquidated or merged.  And those that were bailed out had to write off their bad debts first.  All depositors were covered by an explicit government promise of compensation. The goal was to minimize the cost to the taxpayer, and it succeeded.  It turned out as one of history’s most successful financial system bail-outs.  There are naturally important differences between the situation in Sweden then and the US today.  The most important is that in US most recent bubbles surpassed anything we have ever seen before.  They not only have to deal with a bursting property bubble, but also with the huge leverage effects through the credit markets.  The US has a much bigger problem today than Sweden did then.  Like Sweden, the US needs to shrink its financial sector before saving it.  The difference is that the US needs to shrink it a lot more and wants to shrink it a lot less.

Without a contraction in the financial sector, the US administration risks a debt explosion, and a sudden withdrawal of foreign financial investors.  This is the other big catastrophe looming large in the background.  US is facing two big tail risks from different ends.  Failing to rescue the banking system could lead to a depression.  But so could a rescue if it produced macroeconomic instability.

What about the lesson from the US to Europe?  It is that bank bail-outs require a swift political response.  When you look at the eurozone, it is not clear at all where this response could come from.

Fortis is only one among several large cross-border European banks, all regulated by national supervisors.  And there is no agreement about who pays for a bail-out if any one of them goes down.  One of the drafters of the Maastricht treaty told  once that the lack of an explicit bail-out rule was intended as constructive ambiguity to avoid moral hazard.  But his argument is complacent, and reflects the mindset of that generation of policymakers.  While the Americans need a better rescue plan, the Europeans need a lot more: a system that could produce a rescue plan in the first place.