A more conservative bailout

As the bailout plan was killed in House today, the chance to pass this plan eventually still remains. But the package would be reshaped.

The problem with the original Paulson plan is not merely the lack of direct equity injections but also too aggressive and risky. By purchasing junk securities at above market prices, the plan is indiscriminate in that the bail-out would apply to each bank with junk debt on its balance sheet. It would recapitalise the financial sector in its current form, dosen’t resolve the fundamental problem.

Besides, without a contraction in the financial sector, the US administration risks a debt explosion. Look at the Fed’s balance sheet, it remains a risk that a sudden withdrawal of foreign financial investors. So now American faces two risks from different ends: don’t rescue the financial sector would lead to the depression while a too big rescue package would lead to macroeconomic instability.

Why not learn from history? I already talked about the banking crisis in history and some of them would give us a good lesson.

As in the US, the Swedish financial crisis was also triggered 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 recapitalise the financial sector. 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 minimise the cost to the taxpayer. It turned out as one of history’s most successful financial system bail-outs.

So now the U.S. lawmakers or Paulsons would think about a package similar to Swedish one – a more conservative bailout package would help both sides reach a compromise. It shoud be a hard and painful job to tell good assets from bad assets as Swedish government did, but it’s worthwhile from taxpayers’ standing point. And in the long time, it would help U.S. economy recover soon as only trustable financial institutions stand in the market. So I think more banks with garbages will be gone in next week or so, just as blocks in the way should be removed.