by Ricardo Caballero and Pablo Kurlat
Hank Paulson’s $700bn “bailout” plan unleashed a flurry of alternative proposals, as most people recognize that time is running out. There is an urgent need for a significant intervention to break an accelerating downward spiral that is threatening the very survival of the financial core of the world economy.
Most proposals, including the one just agreed to by Congress, have in common a few general principles. First, they recognize the need to recapitalize the financial system and to improve the liquidity of several key asset and insurance markets. Second, there is agreement on the need to protect taxpayers by giving the government a share of the upside as well. Third, most see moral hazard as a reason to limit the extent of intervention and, in particular, to punish shareholders. Not doing so, the argument goes, would make future crises more likely as it would encourage the financial sector to repeat the excesses that caused the crisis in the first place.
We share the first two “principles” but are less persuaded by the third one. The main problem of the standard moral hazard view is its disregard for the incentive problems it generates within crises. In real life, unlike in many of our models, crises are not an instant but a time period. This time dimension creates ample opportunity for all sort of strategic decisions within a crisis. Distressed agents have to decide when and if to let go of their assets, knowing that a miscalculation on the right timing can be very costly. Speculators and strategic players have to decide when to reinforce a downward spiral, and when to stabilize it. Governments have to decide how long to wait before intervening, fully aware that delaying can be counterproductive, but that the political tempo may require that a full-blown crisis becomes observable for bickering to be put aside. Each of these agents is in the game of predicting what others are likely to do. In particular, the likelihood of a bailout and the form this is expected to take, change the incentives for both distressed firms and speculators within the crisis. These incentives are central, both to the resolution of the current crisis as well as for the severity of the next crises. Read more