Abstract
It has been more than 3 years since the collapse of the investment bank Lehman Brothers and the beginning of the Troubled Asset Relief Program. Most recently, the sovereign debt crisis in Europe has led to the bailout of the governments of Ireland, Portugal and Greece. A main reason behind these bailouts is to support European banks loaded with government bonds on their balance sheet. In this article we analyze the detrimental consequences of the public bailout in 2008 and argue that a free market alternative existed. The alternative of a private bailout outlined in this article, consisting of the conversion of liabilities into equity and a private capital increase, largely avoids the problems of a public bailout. Similarly, a public bailout of governments of the Eurozone to sustain banks may be detrimental.
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Notes
In fact, today maturity mismatching is regarded as the essential business of banking. De Grauwe (2008, p. 37) regards banks as institutions, “which inevitably borrow short and lend long”. They “are in the business of borrowing short and lending long…[providing an] essential service.” See also Adrian and Shin (2008) and Freixas and Rochet (2008) for similar views.
On the limits of credit induced boom see Huerta de Soto (2009, pp. 399–405).
On the dot-com boom and bust see Callahan and Garrison (2003).
On the interaction of regulations in contributing to the crisis see Friedman (2009) and the 2009 special issue on the financial crisis in Critical Review.
On the vicious circle of a liquidity and credit crunch see also Brunnermeier (2009).
Sometimes, economists define a secondary depression as a cumulative process of contraction due to market rigidities caused by government interventions (Huerta de Soto 2009, p. 453). For instance, a secondary depression would occur when in a contraction after an artificial credit boom, rigid wage rates lead to massive unemployment and cumulative downturn. When we refer to secondary depression in this article we mean the liquidation of otherwise healthy companies due to liquidity problems. The business models of the companies would be viable with equity financing.
In fact, as Rothbard (2000, 51, fn. 16) has pointed out, the creditors of a company may be considered a different type of owners. They save and invest money as do equity owners. The more creditors have invested via debt instruments in a company, the less the equity of shareholders. It is, therefore, not a radical change when long-term creditors convert into equity holders. Yet, this change can save a viable business project from unnecessary liquidation.
For a discussion of conditional convertibles that convert debt automatically into equity in case of bankruptcy see Goodhart (2010). In this article we do not pretend to draw a detailed bankruptcy law specifying the valuations of assets, treatment of different creditors, etc. Rather we want to prove on a more general level that a private bailout would have been possible and preferable to the public one.
We should emphasize that a private bailout only prevents a secondary depression. It does not touch the existing structure of fiat money, deposit insurance, government regulation and central banking. This structure must be reformed to prevent a new crisis. A reform proposal, however, lies outside the scope of the present paper. More specifically, a detailed proposal for a certain country is beyond the scope of this article.
We will not discuss the fall of interest rates in the fourth trimester of 2008, although we can briefly point out that it was caused by a drop in demand for credit and by government guarantees.
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Bagus, P., Julián, J.R.R. & Neira, M.Á.A. A free market bailout alternative?. Eur J Law Econ 37, 405–419 (2014). https://doi.org/10.1007/s10657-012-9342-3
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DOI: https://doi.org/10.1007/s10657-012-9342-3