Bailouts or Defaults?

by: John M. Mason

This question is the defining question in finance and economics today.

Yet, the predominant approach used in macroeconomic policymaking does not include debt and the possibility of defaults in its model. So, the policy answer is obvious. The policy makers must “bailout” individuals, banks and businesses, and governments.

Well, forget individuals, let them default.

But, we need to save banks and businesses…and governments. Provide them with cash grants. Provide them with excessive amounts of liquidity. Defaults of banks and businesses and governments are not a part of our theoretical picture of the world.

Look through the book “”Ben Bernanke’s Fed” written by Ethan Harris, a former research officer at the Federal Reserve Bank of New York and published by Harvard Business in 2008. Chapter 2 is called “How the World Works: a Brief Course in Macroeconomics.” Here we get a picture of the basic model the Federal Reserve uses in its analysis of the state of the world.

“Getting into the head of the Fed requires a basic primer on how the economy and monetary policy works, Harris writes, “Nonetheless, a relatively simple framework underlies much of the discussion at central banks today.”

The foundation of the Fed’s analysis, according to Harris is something called “the Phillips Curve” which supposedly captures the tradeoff between inflation and unemployment. This, of course, incorporates the two government policy objectives written into law in 1978 and affectionately referred to as the Humphrey-Hawkins Full Employment Act.

Harris continues that “Bernanke is a proponent of the ‘financial accelerator model,’” which brings the credit market into the picture.

The idea that strong financial and credit conditions and a strong economy can reinforce each other to create economic booms (and that weak conditions can interact to create busts). During booms, both firms and households have stronger incomes and their assets are worth more, encouraging relaxed lending rules. Easy lending makes the economy even stronger and that, in turn encourages even easier lending standards.

In other words, Bernanke, and people within the Fed, believe that pumping credit into the economy produces “stronger incomes” and “assets are worth more.” Thus there is a wealth effect. But, as long as inflation is “in check” there will be no problems on the “real” side of the economy and unemployment will be reduced. BINGO!

However, within this view of the world, there are no problems with debt loads, foreclosures, and bankruptcies. Piece of cake…just throw more spaghetti against the wall! (See “Bernanke’s Next Round of Spaghetti Tossing”.)

Remember, Keynes won and Irving Fisher lost the battle for the hearts and minds of the economics profession. To resolve economic downturns just create more and more debt. Forget about the fact that debt has to be paid off. Just toss more liquidity into the markets.

Defaults are not considered in the model because the assumption is that the problem is one of liquidity, not solvency. (See here.)

Therefore, individuals, banks and businesses, and governments can issue all the debt they want and the Federal Reserve, the European Central Bank, the United States government, or the European Union can step in and solve any discomforting situations that arise through bailouts and loose monetary policy.

However, debt does matter! And, defaults should not just fall on individuals and families. Foreclosures and bankruptcies are very common into the world today.

Yet, governments continue to try and sweep solvency issues “under-the-rug” when it comes to banks and businesses…and to governments.

The only time we really hear about problems of this sort within these institutions is the weekly list of bank closings overseen by the FDIC. But, this information tends to end up on the fifth or sixth page of the business section of the newspaper and rarely, if ever, gets into the radio or television news. Maybe this news, week-after-week, is too boring. However, the FDIC is closing three to four banks a week and they have been doing this for more than a year. Still there are nearly 900 banks on the FDICs list of problem banks, and this does not include a thousand or more banks that are sliding into this problem bank list but have not reached the “statistical” test of being on the list.

This has to be the case within the sector of non-financial businesses. How many small- to medium-sized firms are still on the brink of insolvency? My guess is…a lot. It seems like every week there are more and more empty spaces in the strip malls and other business buildings.

And, then there are the state and local governments. The municipal bond market is in a mess!

In the banking week ending November 19, 2010, the Federal Reserve reports that the average yield on State and Local bonds was 4.72 percent. In the same week 30-year U. S. Treasury bonds yielded 4.30 percent. And, State and Local bonds are not taxed.


Now we get into sovereign debt. Let me just start listing the problems: Greece, Ireland, Portugal, Spain, Italy, France…

Need I say more?

And, what about the United States? On September 30, 2009, the Gross Federal debt outstanding was almost $12 trillion; the Federal debt held by the public was about $8 trillion on that date. And, what if the Gross Federal debt more than doubles over the next ten years as I have been predicting? How acceptable will the debt of the United States government be in the world?


Why isn’t debt included in the models the policy makers use? We can’t continue to operate under the assumption that debt doesn’t matter and that all we need to do, policy wise, is throw more spaghetti against the wall.

People, other than individuals, families, small businesses, and small banks, must come to realize that there is a penalty for taking on too much debt. That penalty is default followed by bringing one’s books under control. People must learn that the solution to issuing debt is not issuing more debt!