Opinion: Bank bailouts: a necessary evil or a moral hazard?

By Paul Li [politics bureau chief]

Dublin, Ireland, Nov 21, 2010: Prime Minister Brian Cowen informs the world that his government has reached an agreement with the European Union and the International Monetary Fund on a bailout for the beleaguered country, who in recent days had seen a run on its banks and a crippling increase in long term interest rates.

The next day, the same Prime Minister is fighting for political life, a battle he may very well lose. How and why did it come to this? Is it necessary?

Ireland’s economic success of the past few years was built on two platforms: one of very low corporate taxes (a flat 12.5 per cent, compared to rates that go up to 50% per cent in other European countries) and a very lax government regulation of the banking sector. This in turn allowed its banks to borrow money from markets and go on a real market shopping spree. As property prices went up, this strategy paid off handsomely, and everyone benefitted. Alas, the happy times did not last, and housing prices fell. As banks started losing money, investors teetered, and threatened to withhold further funding. To avoid a liquidity crisis back then in 2008, the government put in line a fated policy- it would guarantee all loans made by the banks. In other words, anyone lending money to the banks would have such money guaranteed by the Government of Ireland itself.

Flash forward to 2010, and the situation has not improved. The banks continued to lose money, and the government, making good on its promise to guarantee the loans, nationalized the worst offenders- making their debts the public’s debt. The lenders were saved, but now the taxpayers are on the hook. The depositors are not stupid either, they can smell a sinking ship, and have been withdrawing funds and depositing them elsewhere, further weakening the banks. As the government continues to fund bank obligations, the total fiscal deficit balloons to 30 per cent of GDP. Soon, it is the very government that faces its own financing crisis: people are worried that it will be unable to pay its debts and so they charge a higher interest on any loans they make, to compensate for the increased risk.

Fearful of Ireland’s crisis spreading to other countries, the EU and the IMF step up, offering Ireland the money it needs to meet its short term obligations, so that it can pay off its debtors. Problem solved, yes? Well, not really. Let us be clear about what has happened here- the problem with Ireland not being able to pay its debts hasn’t been solved. Ireland has been running a primary deficit- that is, even without debt repayments, its budget doesn’t balance. Unless it makes drastic changes, it will never be able to afford any debt repayments- not now, not ever.

Second, Ireland has chosen to protect its debtors and saddled its taxpayers with the costs. However, these same debtors knew very well that lending to Irish banks and to the Government of Ireland, instead of, say Germany, carried increased risks. And they profited off these risks by getting higher interest payments. If the Government of Ireland will guarantee Irish banks, and the EU/IMF will guarantee Ireland, then the “risks” of making those loans are nil. Investors are thus presented a moral hazard- they earn the profits of the risk, but know that they will not be made to pay if the bet goes sour- and so they will continue pouring funds in.

It is time that the world realize that we cannot continue to reward bad investment behaviour. Just like Wall Street banks profited during the good times, and then presented bills to taxpayers when they lost money, so are Irish banks leaving a big bill to the Irish people. The regulators must learn that, as long as investors are not held responsible for the risks they take, they will continue taking excessively risky bets and ask for the taxpayer to help them when they get it wrong. And the only way to do so is to make investors and debtors take on part of the losses.

As far as this correspondent is concerned, the mistakes to date have cost the world dearly enough. The notion that the taxpayers, whether in Canada or the United States or in Europe, will always cover risky financial bets has to be disabused. Otherwise, not only will we prove to have been unable to contain the financial crisis, but we will have shown ourselves to be unable and unwilling to learn from the mistakes of the past.

Paul Li is a student of Economics and Political Science. A member of the Kwantlen Politcal Science Society, he is a faithful adherent to the words of a wise man, who said “Everyone has a hidden agenda. Except me.”

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