Wednesday, October 08, 2008

Is it really a bail out?

Writing in Business Standard, Percy Mistry contends that the Treasury plan cannot be called out a bail out because the Treasury stands to make profits ultimately on the assets it buys. Assets will be bought at distress prices. Asset prices should improve later. Hence the profit. Banks that have provided for a higher loss than indicated by the Treasury's purchase price can write back provisions. So, it's win-win for Treasury and the banks. Where is the bail out, he asks?

Well, we are quibbling here, aren't we? When we talk of a government bail out, what we mean is that, absent government intervention, firms would fail. A bail out is any move that saves firms from failing through the operation of market forces. By this definition, the Treasury's initiative certainly constitutes a bail out.

If we go by Mistry's interpretation, there was no bail out of LTCM by private parties in 1998- the parties ultimately ended up making a profit on their investment. More to the point, the Indian government's investing Rs 20,000 in public sector banks in1992-93 and the subsequent infusions into Indian Bank and UTI do not constitute a bail out because the government has made a handsome profit on these investments.

On a different note, what is the cost of a banking crisis? Government purchase of assets or infusion of equity capital may not constitute costs to government because these are eventually recouped. Besides, once a loss happens in the banking system, government infusion of capital is merely a transfer- it is not an additional cost because the cost has already happened.

The true cost of a banking crisis is the loss of an economy's output. So, you compare potential output without a bail out with the cost with a bail out and measure the difference. It cannot be Mistry's case that the US economy will not suffer a loss of output if government does not intervene.

1 comment:

Sandeep said...

Great post.