Government Bailout Funds: 'Cause That's Where the Money Is!

I have to wonder, do people really think through their ideas, or are they just in love with the desired outcome? The most dangerous proposals are those where the real outcome is indeterminate but both sides imagine they will get what they want.

The thought that banks should be paying extra fees into a bailout fund so that Government can rescue them in the future is either wishful thinking or an extremely pernicious stab. Current legislation envisions a $50 billion fund created with taxes on financial institutions.

Where is the wishful thinking? The first wish is that $50 billion will be enough to ward off a future credit meltdown. The second, sneakier, wish is that the Government will have $50 billion it didn't have before.

Here is what will really happen: Willie Horton.

What? It is easy: A $50 billion pot of money will soon attract honey-seekers. The money will be there, tantalizing various special interests, seemingly doing nothing. Hence, it will not be in reserve for long. It will be transferred, borrowed, or stolen, for or by special interests via legislation, and will never be available for a bailout. Congressional action will loan it for other purposes. When a bailout really is required, the Government would then have to scrape up $50 billion from other accounts in order to effect the bailout, which will be that much harder to do.

Even worse, banks and financial institutions and their customers will believe that their actions are backed by a $50 billion bailout fund. Moral hazard will be increased, and many will act as though their actions are insured. Because, by gosh, they are insured. No illusions there, seriously! If that's what they've been told, in full faith, why shouldn't they believe it? You certainly can't blame them if they've paid insurance premiums under the impression that they are buying insurance.

The best argument for creating any sort of $50 billion is that it is a "rainy day fund." You save the money, just like an insurance company, against future hardship. The problem is that public finance has proven, over and over, that it an extremely poor steward of capital, and tends to overspend its budget, significantly and repeatedly.

Hence, the correct action to take is passing legislation that encourages the formation of private pools of capital that could intervene in the case of crisis. By encouraging private capital formation, the U.S. gets the benefit of rational self-interest, rewards the best stewards of capital in proportion to their skill, avoids the problems of attempting to retain and maintain public capital, obtains broad and powerful diversification across hundreds of thousands of small pools of capital, and generates a more powerful capital base from which to fund future technological investment.

What shape would such incentives have? The Government could buy special insurance, that would operate in two parts. First, it would pay a direct annual premium against failure of major financial institutions. Each capital pool owner would collect this premium from the Government in proportion to the amount of capital that they would guarantee as being available during a crisis. In the event of crisis, the claim is not for cash, it is for credit. That is, the insurance provider guarantees that they will make a loan available at a particular, contractually agree interest rate. For this loan, the Government also pays the interest. If the insurer is unable to make the loan, they would pay a penalty of multiples of the prior collected premium.

Direct cost to taxpayers of this system would be much lower. Annual premiums would be set by the market, of course, but since the insurer is only guaranteeing liquidity, they can invest their pool of capital elsewhere and still earn a return. The premium would be only a bonus. You can imagine that some of this capital would be in cash, money market funds, in deposits, and in stocks and bonds.

Obviously, the Government is not generating new capital when it makes a claim. Money moves as the insurers may be forced to liquidate stocks and bonds to post some of the claim. More importantly, though, a Government claim more likely forces highly liquid cash investments out of the hands of the insurer to the Government at exactly the time that a TARP-like rescue is required. It is during such crises that many private participants sit on cash hoards as a protection against uncertainty, so although the insurer may have less of a cushion than before, it is unlikely that such a capital claim will force down asset values. This system acts as a circuit breaker, forcing money back into circulation during a crisis when it is needed most.

The premiums paid by the Government could still come from premiums in turn paid by banks and major lending institutions. But such premiums would likely be much less, and the overall flow of funds would be less traumatic for all involved. Even better, the Government could still retain a fund of excess premiums it had collected, which presumably would vary but likely be much less than $50 billion. And there would be no public moral hazard to tap this Government slush fund.

[This post started May 12 and completed May 16.]