The Inevitability Of Bailouts

Author:Paul Wachtel
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.

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