The curse of politics

Financial crises can drag on because efficient remedies are politically unpalatable

AS THEIR banking crisis approaches Japanese proportions, Americans can take comfort from the fact that their political culture is more capable of finding a solution. Or can they? Today’s anti-banker backlash bears a striking resemblance to the voter outrage that stymied efforts to fix Japan’s banking system in the 1990s. Indeed, an enduring lesson of financial crises is how political constraints interfere with economically efficient solutions.

For example, America’s Treasury and the Federal Reserve began examining options to use public money to buy up illiquid mortgage assets and to inject capital into financial institutions shortly after rescuing Bear Stearns, a failing investment bank, in March 2008. But it was another six months before they acted on those plans. “There was no way we could go to Congress without the American people understanding we faced a crisis,” says Henry Paulson, the treasury secretary at the time.

Sure enough, not until the failure of Lehman Brothers sparked a global panic in September did Mr Paulson and Ben Bernanke, the Fed chairman, ask Congress to authorise an outlay of $700 billion to support the system. Some say Mr Paulson should have tried harder to acquire the funds before the Lehman crisis. Perhaps, but it is doubtful he would have succeeded. “Even at the height of the crisis, [that] proved almost too hard to do,” he notes.

Phillip Swagel, an economist who will join Georgetown University this autumn, writes in a review* of his experience as an aide to Mr Paulson from December 2006 to January 2009 that market participants and academic economists often proposed solutions that glossed over real-world political and legal obstacles. Some academics argued bank creditors should be forced to swap their debt for equity, for example. But Mr Swagel notes that is not legally possible without a change in the bankruptcy code, a tortuous political process. Similarly, to reduce housing foreclosures the Treasury and Congress focused on reducing interest rates for struggling homeowners, even though this would be less effective than subsidising write-downs of mortgage principal. But politicians and voters would have seen that as an unacceptable bail-out of some undeserving homeowners.

Economists have long studied how institutional constraints interfere with efficient economic choices, such as when special interests erect barriers to entry in product markets. Such constraints have received relatively little attention in the burgeoning literature on financial crises. Yet a closer examination shows that many of the same political obstacles crop up from one crisis to the next. Japan’s Ministry of Finance first sought private-sector solutions to its banking crisis so as not to arouse voter anger by using taxpayers’ money. When those solutions failed, the government proposed in 1995 spending a mere ¥685 billion ($7 billion) to take over the problem loans of seven jusen, or mortgage-finance companies. The backlash was intense. Opposition parties called for the finance minister’s resignation and staged a sit-in at parliament. In one poll, 87% of voters disapproved. The measure eventually passed, but the experience was so searing that it discouraged the government from tackling the banks’ much bigger bad loans until 1997.

In spite of these difficulties, some governments do negotiate the political shoals. South Korea is often praised for the speed and forcefulness with which it took over failing banks and bought up bad loans following its financial crisis in 1997-98. But the South Korean government was able to deflect public anger by arguing that it was being forced to take these steps by the IMF, which to this day most Koreans blame for the crisis.

Sweden took over two banks and issued a blanket guarantee of bank liabilities in the early 1990s even though the governing coalition did not have a majority in parliament. Bo Lundgren, the finance minister at the time, says Swedish voters would have rejected the bail-out had it been put to a referendum. But the government first ensured it had the support of the opposition party (from whom it had inherited the crisis) and then obtained authority from parliament for unlimited funds, so it did not have to return for more money later.
This time it’s not different

A blank cheque would greatly suit Barack Obama, who gave warning on April 14th that American banks may “require substantial additional resources”. Mr Obama has pencilled in another $750 billion of potential stabilisation funds in his 2010 budget but unlocking extra money will be extremely tricky. Despite commanding majorities in Congress and high personal-approval ratings, he must overcome solid opposition from voters jaded by revelations of bankers’ excess.

That may well mean violating certain economic principles. Economists generally prefer transparent to hidden subsidies. But Mr Swagel says that the Treasury came to realise that underpricing insurance for bank assets roused less political opposition than overpaying for assets precisely because the insurance is less transparent. The Treasury is also relying on the Fed to finance illiquid assets by printing money because that requires no congressional approval (even if it compromises the Fed’s independence).

The other temptation is to couple assistance for bankers with a hefty dose of punishment to sate the public’s hunger for justice. Sweden sued the boards of the two banks it nationalised. Several executives agreed to repay their “golden-handshake” severances to avoid prosecution. Mr Obama promised that if banks need more aid, “we will hold accountable those responsible.” The risk, of course, is that pandering to voters’ anger only inflames them further, and makes it even harder to put money into the banking system as need arises.