Lorenzo Bini Smaghi, a member of the ECB Executive Board, penned an op-ed in the FT today entitled "It is better to have explicit rules for bail-outs." Given the relative simplicity and directness of such a title, one would expect the piece to lay out the logic behind such a statement. Instead, what follows is largely nonsense,and self-contradictory blather.
Let's begin:
"One of the many lessons we can draw from the financial crisis... is that economic agents do not always behave rationally, especially when they take decisions affecting others. Research has shown in particular that agents are not only motivated by self-interest, as economists are keen to believe, but also by considerations of fairness."
A strong start - I'm with you so far, Lorenzo.
"Such attitudes make it difficult for governments to act consistently in times of crisis, especially when elections are close. This was notably the case in September 2008, shortly before the US presidential election, when Congress, despite the gravity of the situation, rejected the government's bail-out plan until Lehman Brothers' failure made it apparent that the risk of financial collapse would have devastating effects for all."
Mmmkay - not the best example. Congress rejected the government's bail-out plan not out of considerations of fairness, but because the Democrats tried to ram it down the throats of Republicans too blinded by ideology and obstructionist predispositions. Maybe our author is trying to be polite.
Regardless, he believes that democratic governments cannot be relied upon to react swiftly to address crises:
"Systems and institutions with specific crisis-resolution mandates thus need to be established to permit rapid responses."
Therefore: clearly established, fixed procedures for bailing out (woops, "resolving") an institution in crisis to prevent contagion is the way forward. Would this not create moral hazard? Would not this not allow the clever folks at large banks, investment firms, and hedge funds to find ways around the fixed rules, just as they have consistently done in the past? Would it not be better to provide regulatory bodies with resolution powers that are both broad and ambiguous enough to create uncertainty for financial actors as to when/how they might get bailed out in the future? Would this not go some distance to preventing them from gaming the system just as they have consistently done in the past?
Lorenzo's argument seems to be that elected officials should not be trusted to solve problems in the heat of the moment. There is some truth to this: it's messy and leaves you vulnerable to political cycles and populism. Ad hoc crises resolution efforts at the national level can also make things worse at the international level - we saw this with Ireland's unconditional guarantee of bank liabilities back when the crisis was as its worst.
But it does not follow that iron-clad rules need to be laid out in all cases. Fixed rules based on the last crisis are almost certainly not going to be well-suited for the next one - we do not want to train our generals to fight the last war. Smaghi does not seem to have grasped this fundamental lesson from history at all:
"Moral hazard should ... be addressed by establishing institutions and procedures that allow for incentive-compatible solutions (carrots as well as sticks). This means, in particular, that financial assistance, if needed to avert a major systemic crisis, can be granted on strict conditions that aim to prevent any recurrence of the problem."
Really? Any recurrence of the problem? Please don't insult your readers with this drivel. Finally:
"[M]oral hazard cannot be tackled simply by assuming that crises will not occur. Nor can it be assumed that letting an institution or a country fail is always and everywhere the most desirable solution, as the post-Lehman experience has shown. Decision-makers in both the public and private sectors must thus be ready to deal with worst-case scenarios and make sure that they are not prevented from delivering the appropriate decisions."
Aside from stating the blindingly obvious, I read this last paragraph undermining Smaghi's argument entirely. Given the fact that the next crisis will not be identical to the previous one, flexibility is key. "Explicit rules for bailouts" is not flexibility, and is certainly not going to equip decision-makers with the capacity to deal with worst-case scenarios. Indeed, explicit rules may very well prevent them from delivering appropriate decisions.
*deep breath*
Flexibility essentially means power. The debate that we should be having is over how much power financial regulators should have/are able to use effectively. How much should we be able to rely on this power? Will it dampen the inherent moral hazard of future government bailouts?
Smaghi's argument is not so much an argument but rather a vague collection of statements that are tenously linked together, not particularly convincing, and seemingly self-contradictory. He has contributed nothing but confusion.
