The Inevitability Of Bailouts

• Author: Paul Wachtel
• Pages: 57-57

March 2018 | FINANCE & DEVELOPMENT 57

BOOK REVIEWS

The Inevitability

of Bailouts

ECONOMICS SAYS THAT bailouts are bad because

they beget moral hazard—that is, they shield

those involved from risk, which encourage s reck-

lessness. Politics seems to agree: t he no-more-bail-

outs sentiment was a driving force behind the

2010 massive US nancial reform legislation

known as the Dodd-Frank Ac t. e global nan-

cial crisis’s 10th anniverary r aises the question of

whether we are better poised to dea l with future

crises. Eric Posner’s response is a resounding no.

In Last Resort Posner’s argument rests on three

points. First, he argues that much of the response

both by the Federal Reser ve and the US government

to the 2008 subprime crisis was il legal. Second,

future crises wi ll inevitably require bailouts or liquid-

ity provision by a lender of last resort (LLR). ird,

we still don’t know how to provide an LLR legally

and eectively in a crisis . Much space is devoted to

the rst point, leaving sca nt opportunity to address

the challenge of design ing adequate (and fully) legal

policy tool s.

e 19th century concept of an LLR is a ll about

liquidity for solvent institutions in crisis. But today

distinguishing between liquidity and solvency

problems is often impossible. It is still a matter of

debate whether Lehman Brothers wa s insolvent or

just illiquid in September 2008. Simil arly, the legal

battles Posner analyz es regarding the insurer A IG

and the government-sponsored housing enterprises

hinge on the question of insolvency or illiquidit y

when the government intervened. It is hard to

make this distinction, so bailouts are inevitable,

and there must be rules for liquidity support. If

anything , Dodd-Frank limited the Fed’s ability to

react. Other Dodd-Frank provisions may reduce the

probability of a crisis, but if there is one, we may be

less able to res pond.

Posner has no sympathy for the idea that the Fed,

operating under extreme conditions, wa s innovative

and creative in its crisis response . He presents a legal

brief on why the government intervention to “take”

the equity of AIG and of the government-sponsored

housing agencies was il legal, as opposed to bailouts

of worthless organi zations. Not until the last three

lines of the book does he acknowledge h is work on

AIG’s legal case aga inst the government.

In the last chapter, Posner turns to the design of

a postmodern LLR. L egislation can never guara n-

tee that crises will not occur, so bailouts will still

be needed. Posner would like to see an LLR with

broad powers to lend when collateral is unavaila ble

or impossible to value, make capital inject ions, and

direct rms to enter nancial transactions. His

strengthened LLR could make scal or expendi-

ture commitments, crossing t he line that separates

traditional central banking from the government.

Would any legislator give such extensive author-

ity to an independent nancial reg ulatory body?

It is a troubling conclusion: the modern nancial

system requires an LLR with powers no political

structure is likely to grant.

PAUL WACHTEL, Stern School of Business, New York University

Eric A. Posner

Last Resort: The

Financial Crisis and the

Future of Bailouts

University of Chicago Press,

Chicago, IL, 2018, 272 pp., $27.50

Today distinguishing between

liquidity and solvency

problems is often impossible.