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October 25, 2009

Economist's View - 3 new articles

"Governments Must Not Bail Out Bondholders"

Lucian Bebchuk says there's no need for the government to protect bondholders in a financial crisis:

Governments must not bail out bondholders, by Lucian Bebchuk, Commentary, Project Syndicate: A year after the United States government allowed ... Lehman Brothers to fail but then bailed out AIG,... a key question remains: when and how should authorities rescue financial institutions?
It is now widely expected that, when a financial institution is deemed "too big to fail", governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts,... the government's safety net should never be extended to include the bondholders of such institutions.
In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government's infusion of cash. ... Bondholders were saved because governments generally chose to infuse cash in exchange for common or preferred shares – which are subordinate to bondholders' claims – or to improve balance sheets by buying or guaranteeing the value of assets.
A government may wish to bail out a financial institution and provide protection to its creditors for two reasons. First,... a protective government umbrella might be necessary to prevent inefficient "runs" on the institution's assets that could trigger similar runs at other institutions.
Second, most small creditors are ... unable to monitor and study the financial institution's situation when agreeing to do business with it. To enable small creditors to use the financial system, it might be efficient for the government to guarantee (explicitly or implicitly) their claims.
But, while these considerations provide a basis for providing full protection to depositors and other depositor-like creditors..., they do not justify extending such protection to bondholders.
Unlike depositors, bondholders generally are not free to withdraw their capital on short notice. They are paid at a contractually specified time, which may be years away. Thus, if a financial firm appears to have difficulties, its bondholders cannot stage a run on its assets and how these bondholders fare cannot be expected to trigger runs by bondholders in other companies.
Moreover, when providing their capital to a financial firm, bondholders can generally be expected to obtain contractual terms that reflect the risks they face. Indeed, the need to compensate bondholders for risks could provide market discipline: when financial firms operate in ways that can be expected to produce increased risks down the road, they should expect to "pay" with, say, higher interest rates or tighter conditions.
But this source of market discipline would cease to work if the government's protective umbrella were perceived to extend to bondholders... Thus, when a large financial firm runs into problems that require a government bailout, the government should be prepared to provide a safety net to depositors and depositor-like creditors, but ... the government should not provide funds (directly or indirectly) to increase the cushion available to bondholders.
Rather, bonds should be at least partly converted into equity capital, and any infusion of new capital by the government should be in exchange for securities that are senior to those of existing bondholders.
Governments should ... make their commitment to this approach clear in advance. ... This would not only eliminate some of the unnecessary costs of government bailouts, but would also reduce their incidence.

Anything that imposes the costs of the bailout on the people participating in the markets rather than on taxpayers without compromising the ability to protect the financial system (or, as claimed above, even enhancing the protective shield) is ok with me.

"The Roots of Protectionism in the Great Depression"

Lessons from the Great Depression:

The Roots of Protectionism in the Great Depression, by Laurent Belsie, NBER Reporter: The Great Depression was a breeding ground for protectionism. Output fell, prices declined, and unemployment rose, pressuring governments to do something to revive their economies, even if that meant limiting imports. But contrary to popular perception, some countries went much further down this protectionist road than others, according to "The Slide to Protectionism in the Great Depression: Who Succumbed and Why?" (NBER Working Paper No. 15142). Co-authors Barry Eichengreen and Douglas Irwin conclude that a key factor behind this variation in trade policies was nations' adherence to the gold standard. Those countries that clung to the gold standard were more likely to restrict trade than those that abandoned it.
Previous research has shown that countries that remained on the gold standard tended to endure sharper and longer downturns than those that allowed their currencies to depreciate. Eichengreen and Irwin offer an important trade-policy corollary: without the flexibility to depreciate their currencies, many gold-standard nations turned to trade restrictions in hopes that these would boost their domestic industries and curb unemployment. Thus, the 1930s' rush to protectionism was not so much a triumph of special-interest politics as it was a result of second-best macroeconomic policies, the authors write. Their study "suggests that had more countries been willing to abandon the gold standard and use monetary policy to counter the slump, fewer would have been driven to impose trade restrictions."
Eichengreen and Irwin focus on three groups of countries that emerged from the wreckage: Britain and the sterling bloc, which abandoned gold and largely avoided boosting trade barriers; France and the gold bloc, which stayed on the gold standard and resorted to protectionist measures; and a group of countries led by Germany that imposed draconian controls on trade and payments in a way that also effectively protected their economies from imports. By looking at three measures of commercial policy – import tariffs, import quotas, and exchange controls -- the authors are able to gauge how these blocs reacted to the pressures facing them as trade began to collapse in mid-1931.
Although each measure is relatively crude, all three paint the same broad picture. Between 1928 and 1938, the average tariff (as a percentage of the value of imports) did not change in any major way for three of the four sterling-bloc nations. (The exception, Britain, raised tariffs for internal political reasons, the authors contend). By contrast, the average tariff soared between 1928 and 1935 for all four gold-bloc countries (France, Belgium, the Netherlands, and Switzerland) and three of the five exchange-control nations (Austria, Germany, and Italy). The two exceptions -- Czechoslovakia and Hungary – had such rigid foreign-exchange controls that they didn't need high tariffs to keep out imports.
League of Nations data on import quotas for eight nations in 1937 points to the same trend: the sterling-bloc countries relied on them less than gold-bloc countries did. Similarly, few sterling-bloc and other currency-depreciating nations imposed exchange controls while those that stuck with the gold standard often did. Between 1928 and 1935, exchange-control nations on average reduced imports some 26 percent more than what would be expected from the change in their real GDP, the authors calculate. "This suggests that controls were a significant factor in reducing international trade," they write.
In a more detailed analysis of changes in tariffs and exchange rates for a group of 21 mostly European nations and a larger sample of 40 countries between 1928 and 1935, the authors find the same trend: those that abandoned the gold standard were less likely to increase import tariffs. There is fair bit of variation from the average, though, partly because of certain national idiosyncrasies (such as Britain's internal political dynamics), partly because of additional factors across countries (such as whether they were international financial centers or had recently experienced high inflation). Either of these latter factors would have made a nation more reluctant to abandon the gold standard, the authors argue. Indeed, when they control for these factors, the results reinforce the conclusion that there is a strong relationship between the change in the exchange rate and the change in import tariffs.
Remaining on the gold standard fueled protectionism, but the countries that left the gold standard began to liberalize their trade policies. The United States, for example, delinked in 1933 and a year later enacted the Reciprocal Trade Agreements Act, which gave the President the authority to trim import duties in foreign-trade agreements. Once France went off gold in 1936, it began eliminating import quotas.
Parallels between the Great Depression and today have raised fears of a new slide toward protectionism. But the policy tools in the modern era are different, the authors write. In the 1930s, stimulus meant monetary stimulus, which tended to depreciate the nation's currency and make its products cheaper in export markets. Such moves tempted other nations to impose trade barriers. Today, besides monetary stimulus, nations are using fiscal stimulus that boosts domestic demand and helps not only the nation that uses it but also those countries that export to it. Thus, the temptation to restrict imports now rests with nations enacting such stimulus. The "Buy America" provisions in the 2009 U.S. federal stimulus package are one example.

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