Bailout: Importance and Criticisms

Bailout: Importance and Criticisms

A bailout is a colloquial term used to describe the actions and decisions involving the provision of financial assistance to a business organization, a specific industry or sector, or in some situations, a country or government to save it from bankruptcy or financial failure. The financial assistance may take the form of a loan, the purchasing of stocks or bonds, or the infusion of cash and capital. Furthermore, although financial institutions and other businesses can extend bailout programs, governments typically bailout companies for economic reason.

Pros: Arguments About the Importance of Bailout Programs

One of the primary arguments in support of bailout centers on the need to address the consequences that tag along with the potential downfall of a business organization or a specific industry or sector. Some of these consequences include bankruptcy, defaults on financial obligations, and closure. They can affect not just the interest of the potentially failing entity but also the interests of its stakeholders.

There are different specific reasons companies extend financial assistance to other companies. For example, a manufacturer might decide to offer its troubled supplier a loan to preserve the integrity of its supply chain. Another company might also acquire its struggling competitor to capitalize on its technology or expand its existing market share. Bailouts can also serve as a component of a market entry strategy.

In government bailout programs, the justification is based on economic intervention and more specifically, on Keynesian economics and fiscal policy. A government may choose to step in and save struggling companies or industries, especially if their potential downfall would severely affect the economy due to a possible negative impact on employment and inflation levels, the investment environment, and gross domestic output.

The U.S. government has a long history of bailouts. For example, during the subprime mortgage crisis that further resulted in the 2007-2008 Financial Crisis, the government tried to save the American financial markets by bailing out banks. The Federal Reserve rescued American International Group or AIG with a USD 85 billion loan.

On 3 October 2008, then U.S. President George W. Bush signed the Emergency Economic Stabilization Act that involved a plan for bailing out companies for USD 700 billion. The law marked one of the massive bailouts in history. Further efforts to stimulate the depressed American economy due to the financial crisis included bailing out major automobile manufacturers, particularly Ford Motor Company, General Motors, and Chrysler, through a loan package worth USD 80.7 billion.

Governments in the European Union also rolled out bailout programs to rescue several European banks and their members. In 2010, for example, Ireland bailed out the Anglo English Corporation for over USD 29 billion. EU extended an amount of USD 360 billion to Greece to help the struggling country manage its debts and spiraling spending deficits.

The European Commission and the International Monetary Fund, and with the technical assistance of the European Central Bank, collectively became the European Troika. These institutions represented bailout creditors. They were key decision-makers and thus, a decision group tasked in matters concerning the need to determine the extent at which they would extend financial assistance to banks and governments or countries.

It is also essential to highlight the fact that one of the primary purposes of central banks or central monetary authorities is to function as lenders of last resort. As an example, the U.S. Federal Reserves provides loans to banks or other eligible institutions that do not have any means of raising funds, particularly if their financial failure would significantly affect the economy.

Cons: Arguments Against or Criticisms of Bailout Programs

There are criticisms, and thus, arguments against bailouts. One is concern over raising moral hazard. Note that in economics, a moral hazard occurs when a business or institution increases its exposure to risks because it is confident that others would bear the cost of such risks. Bailout programs essentially provide businesses an assurance of safety nets, thus encouraging risk-taking and lowering their standards.

A study by Lammertjan Dam and Michael Koetter tested if safety nets create moral hazard in the German bank industry revealed a relationship between expected bailout probabilities and risk-taking. Findings specifically showed that an increase in expectations from one standard deviation below the mean to one standard deviation above the mean implies an increase in predicted distress probabilities by 3.2 percent. Note that the study estimates moral hazard as the sensitivity of distress probabilities.

Politician and former U.S. Representative Ron Paul also argued that bailing out failing companies essentially mean confiscating money from productive members of the economy and giving them to failing ones. He added that by bailing them out, the government prevents these failing companies with obsolete or unsustainable business models from liquidating their resources for better and more productive use.

Businesses should also be left to succeed and fail on their own merits. Critics noted that a free market economy has a simple mechanism for rewarding these organizations. To be specific, success, as determined by profitability, productivity, and longevity, is the reward earned by hard-working businesses. However, in bailing out troubled businesses, the government is reversing and defeating the purpose of economic reward. The government should maintain the integrity of the free market by permitting both success and failures.

Classical economics also maintains that the free-market capitalist economic system is an economic system with its mechanism for self-regulation. Thus, it contends further that government intervention should be minimal. Adherents of this school of thought also argue that interventionism is dangerous because it discourages business investments and innovation.

Pros and Cons in a Nutshell: Summary and Takeaways

Below are the arguments about the importance of bailout:

• There are situations in which an individual company bails out another company to promote or secure its own interest. An example would be a manufacturer bailing out one of its critical supplier or an investment bank bailing out one of its biggest clients.

• Investors can benefit from bailing out other companies in several ways. They can take advantage of reduced investment costs. In addition, they can acquire failing competitors to better capitalize on its technology or expand their existing market share.

• In governance, one of the arguments in support of government bailout programs centers on the need to intervene and rescue failing companies or industry and sector, especially if their potential downfall would severely affect the economy.

• A key argument for bailouts centers on adherence to Keynesian economics or depression economics. During economic downturns, infusing capital to struggling businesses or industries and sectors can help stimulate the economy.

The following are the arguments against or criticisms of bailout:

• The availability of bailout increases economic moral hazard because it gives businesses an assurance of having a safety net, thus lowering their standards, encouraging their exposure to risks, and lessening accountability.

• Bailing out troubled companies defeats the purpose of the free market. A free market economy has a mechanism for rewarding high-performing companies. Bailing out struggling companies means rewarding them for their failures.

• The taxpayers shoulder the costs of bailout programs. Essentially, the government channels money from taxpayers to failed companies. Critics have maintained that this is unfair. Productive members of the economy should be rewarded.

• Normalizing bailouts essentially means encouraging businesses to be irresponsible with their decisions. It promotes a mindset that the government and the taxpayers will always be there to bear the costs of risk-taking.

FURTHER READINGS AND REFERENCES

  • Council on Foreign Relations. n.d. “The U.S. Financial Crisis: 1992-2018.” Council on Foreign Relations. Available online
  • Dam, Lammertjan and Koetter, M. 2011. “Bank Bailouts, Interventions, and Moral Hazards.” Bundesbank Series 2 Discussion Paper No. 10/2011. Deutsche Bundesbank. Available online
  • Hölmstrom, B. 1979. “Moral Hazards and Observability.” The Bell Journal of Economics. 10(1): 74-91. Available online
  • Paul, R. 2008, September 23. “Commentary: Bailouts Will Lead to Rough Economic Ride.” CNN. Available online