Monday, November 28, 2011

How Does a Bail-Out Work?

This bailout's not working.
There's a story circulating around the internet that goes something like this:  "It is a slow day in a little Irish town.  The streets are deserted.  Times are tough, everybody is in debt and everybody lives on credit.  On this particular day a German tourist comes to town, stops at the local hotel, and lays a 100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night.  The owner gives him some room keys and, as soon as the visitor has walked upstairs, the hotelier grabs the 100 note and runs next door to pay his debt to the butcher.  The butcher takes the 100 note and rushes down the street to repay his debt to the pig farmer.  The pig farmer takes the 100 note and heads off to pay his bill at the Farmers' Co-op.  The guy at the Co-op takes the 100 note and runs to pay his bar bill at the pub.  The pub owner slips the money along to the local prostitute at the bar who has provided him her services on credit.  The hooker then rushes over to the hotel and pays off her room bill to the hotel owner with the 100 note.  The hotel proprietor replaces the 100 note back on the counter.  The German comes down the stairs, states that none of the rooms are satisfactory, picks up his 100 note, and leaves town.  No one has produced anything.  No one has earned anything.  However, the whole town is now out of debt, and looking to the future with a lot more optimism.  And that, dear ladies and gentlemen, is how a basic financial bailout works!"  Or is it?  This may be an example of the "multiplier effect" of money, and perhaps illustrates "liquidity" in credit markets - perhaps even the concept of "moral hazard" because only this small circle of the town's businesses benefited from the infusion of cash - but real-world bailouts are much more problematic.  First, nobody "antes up" before doing their due diligence (except maybe the U.S. congress), so the whole scenario falls apart at the outset.  However, let's assume the tourist did put down the 100 note as a deposit on the keys.  The biggest problem is that all recent bailouts went to financial institutions (and the auto industry in the U.S. - moral hazard again) who didn't pass it on to businesses as low interest loans to expand and hire, but did fund their own exorbitant executive compensation schemes.  There are lots of other incongruencies in the above fable, but the main point to remember is that bailouts can keep an economy on life support temporarily but a true recovery requires new economic activity - in this case the German tourist staying overnight, and spending money in the town.