ChainWhat it assumes · how to break it
Start
The government and central bank rescue failing banks, as the UK did by buying large shareholdings in RBS and Lloyds in 2008.
1
As a result, the government borrows to buy the shares and fund guarantees, so public sector debt rises.
national debt · bailout
national debt · bailout
Best link to attack
Assumes: The money spent is lost.
Assumes: The money spent is lost.
But: The government receives shares that can be sold later, so the lasting cost depends on the sale price.
2
In addition, the government may have to cover further losses if the value of the banks' assets keeps falling.
contingent liabilities
contingent liabilities
Assumes: The banks' losses keep growing.
But: If asset prices recover, guarantees are never called on and may even earn fees.
3
At the same time, rescuing the banks prevents a wider collapse of lending, so the recession is shallower and tax receipts fall less than they otherwise would.
automatic stabilisers · counterfactual
automatic stabilisers · counterfactual
Assumes: Without the rescue, the crisis would spread through the financial system.
But: If the failing bank is small and not closely linked to others, its failure would not spread and the rescue cost would be wasted.
4
Therefore, the deficit widens in the short run, although by less than the headline cost of the rescue once the avoided recession is counted.
budget deficit
budget deficit
Assumes: The rescue works.
But: If the rescue fails to restore confidence, the government may face a deeper recession and further rescues.
5
Consequently, banks that expect future rescues may take more risk, raising the chance that the government faces further bailout costs later.
moral hazard
moral hazard
Assumes: Banks expect to be rescued again.
But: If shareholders lose most of their money and senior managers are replaced, as at RBS, the rescue is a warning more than a reward.
End
Government borrowing and debt rise in the short run, although the lasting cost depends on what is recovered from the rescued banks and the recession avoided.
Evaluation chain
- E1However, the lasting cost to the public finances depends on what the government recovers when it sells its stake.
- E2If the rescued bank returns to profit, its shares can be sold at or above the price the government paid.
- E3As a result, the bailout may cost taxpayers little in the end; the UK recovered roughly what it paid for its Lloyds shares, but sold its RBS shares for less than it paid.
- E4So the effect on the fiscal balance may be largely temporary, and whether it is small or large depends on the health of the rescued bank.
Another way to attack it: Judging the fiscal cost needs a counterfactual: letting large banks collapse might have caused a far deeper recession, with much larger falls in tax receipts than the cost of the rescue.
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Questions this answers
- Assess the impact of bank bailouts on the government's fiscal position.
- Evaluate whether governments should rescue failing banks.
- Discuss the extent to which bank bailouts create moral hazard.
Diagram
No standard diagram. Evidence of the UK's share sales in Lloyds and RBS works well to show the lasting cost.
Reverse and related
Letting banks fail → no direct rescue cost, but a deeper recession could widen the deficit through lower tax receipts and higher benefit spending.