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The Efficiency of Political Bailouts

- February 14, 2010

Matthew Yglesias rightly writes that:

politicians who claim that if it were up to them they would provide bailout-free governance are just lying.

Most of us would agree that a commitment by politicians never to bail out debtors is not credible. But is this a bad thing? A 2002 article by Patrick Bolton and Howard Rosenthal (my dissertation advisor) in the Journal of Political Economy argues that the opposite is true: under a wide range of conditions it is both ex ante and ex post efficient to allow a political process to determine if and when bailouts occur. The article is mostly motivated by the Panic of 1819 but has some interesting implications for the more recent bailouts.

The problem with bailouts is that they make sense at the time of a crisis but if creditors expect bailouts whenever loans go bad this may cripple credit markets. The difficulty for any society is to figure out a mechanism by which bailouts only occur in the unusual circumstances that warrant them. Bolton and Rosenthal analyze how majority rule performs this function in a simple farm economy. Even if the majority of people are debtors rather than creditors, it is rarely in the interest of a majority to favor bailouts. This is not just so because debtors may fear that such action may limit their access to credit but also because there are some benefits to seeing others go bankrupt. In the Bolton-Rosenthal model this is because farmers that are bankrupted enter the regular labor market and thus drive down the price of labor.

Such benefits cease to exist, however, in times of severe economic crises when there are many simultaneous failures. In bad economic times, the richer farmers have no demand for additional labor. Moreover, large numbers of defaults constrain access to credit for poorer farmers who are not defaulting, thus resulting in underinvestment. In this circumstance, most people are better off if the farmers that have difficulties repaying their debts stay on their farms where they can be more productive. A brief moratorium makes sense and is favored by the majority. The political process helps to fill in some of the inefficiencies that result from the incompleteness of debt contracts (i.e. their inability to include contingencies for macro-economic crises). This improves efficiency if such crises are relatively rare and unpredictable.

There are some obvious analogies with the mortgage crisis. Most notably, foreclosures not only cause personal hardship but also increase the supply of houses precisely at a time when there is no demand. The wealth losses that come with this put a downward pressure on investment precisely at a time when investment was needed most. Moreover, even if houses are not farms, it is not unreasonable to presume that there are substantial productivity losses associated with this many people losing (or threatening to lose) their homes. This suggests that a brief moratorium on mortgage payments may have been an idea that should have warranted more serious attention. I suspect that the long-term impact on credit markets would not have been nearly as disastrous as some were predicting: it is simply almost never in the interest of voters to impose such a moratorium. That said, I am really not an expert on this issue so I should probably just shut up. Here is the abstract:

This paper develops a dynamic general equilibrium model of an agricultural economy in which poor farmers borrow from rich farmers. Because output is stochastic (we allow for idiosyncratic and aggregate shocks), there may be default ex post. We compare equilibria withand without political intervention. Intervention takes the form of a
moratorium and is decided by voting. When bad economic shocks are highly likely, state-contingent debt moratoria always improve ex post efficiency and may also improve ex ante efficiency. Moreover, the threat of moratoria enhances efficiency. When adverse macro shocks are unlikely, state-contingent moratoria always improve ex ante welfare by completing incomplete debt contracts.

ps. Some of this is based on conversations during Howard Rosenthal’s 70th birthday conference at Princeton.