The Economists' Alternative to Bailouts

by Garett Jones

I'm still shocked at the speed with which bipartisan elites coalesced around TARP. A key reason: The proffered alternatives were incredibly painful. No bailouts would have meant bankruptcies much bigger and more complicated than Lehman--and that bankruptcy ostensibly threatened short run cash flows around the world. Voters don't want pain. Yes, some voters want to see virtue rewarded and wickedness punished--they may even claim that the pain is good for you--but the rest of us want our medicine to taste good. This stark choice between 100% bailouts and a cluster of possibly 1907-panic-inducing megabankruptcies was totally unnecessary.  Did the big banks need equity injections?  Well, there were plenty of potential shareholders available for Citi, BofA, and all of the other TARP recipients.  And they had a name: "bondholders." The economist's version of bankruptcy (not the lawyer's version) is simple: If what you contractually owe is (very likely) greater than the value of your assets, then you're bankrupt.  It's not primarily about missing a payment: It's about the prediction that you won't be able to repay everyone you've made promises to.  If your assets can't pay off all your debtholders (including depositors) then it's time to head to court. But all corporate bankruptcy means (again, to an economist, not a lawyer) is that some of the bondholders get turned into shareholders: Instead of getting the $10,000 you were owed, you get shares that will probably be worth much less.  In the simplest case, the shareholders get nothing (they had their chance to run the firm and blew it), the bondholders become the new shareholders, and the firm keeps right on running.  Seems like something you could do over a weekend...Continue reading at econlib.org...image: flickr.com/doctorious 

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