The Lingering, Hidden Costs of the Bank Bailout

Why is growth so anemic? New economic activity has been discouraged. Here are some ways to change that.

Click here to read this WSJ article by Noble prize winner Vernon L. Smith. Excerpts:

"New economic activity is hobbled if it is not freed from the burden of sharing its return with investors who bore risks that failed. The demand for new economic activity is enlarged when its return does not have to be shared with former claimants protected from the consequences of their risk-taking."

"Requiring new investment to share its return with failed predecessors is tantamount to having required Henry Ford to share the return from investment in his new horseless carriage with the carriage makers, livery stables and horse-breeding farms that his innovation would render obsolete. 

This burden on new investment helps explain the historically weak recovery since the "Great Recession" officially ended in June 2009, and the recent downturn in gross-domestic-product growth." 

"Japan and Sweden are examples of economies that followed distinct pathways after crises in the early 1990s. In Japan the economy floundered in slow growth for over two decades; Sweden recovered much more quickly. The difference can be attributed to following different policies in the treatment of severe bank distress."

"Japanese policy permitted banks to carry mortgage loans at book value regardless of their accumulating loss. Loans were expanded to existing borrowers to enable them to continue to meet their mortgage payments. This response could be rationalized as "smoothing out the bump." Bank investors were protected from failure by stretching out any ultimate return on their investment, relying on a presumed recovery from new growth that never materialized. This accounting cover-up was coupled with government deficit spending—tax revenues declined and expenditures rose—as a means of stimulating economic growth that was delayed into the future."

"From the beginning Japan was caught in the black hole of too much negative equity. The banks, burdened with large inventories of bad loans, geared down into debt reduction mode, reluctant to incur more debt, much as their household mortgage customers were mired in underwater mortgages and reluctant to spend. The result was a decade of lost growth that stretched into and absorbed a second decade of dismal performance. The policy cure—save the banks and their incumbent investors—created the sink that exceeded the pull of recovery forces."

"Sweden's response to deep recession in the early 1990s was the opposite of Japan's: Bank shareholders were required to absorb loan losses, although the government financed enough of the bank losses on bad assets to protect bank bondholders from default. This was a mistake: Bondholders assumed the risk of default, and a bank's failure should have required bondholder "haircuts" if needed. Nevertheless, the result was recovery from a severe downturn."

"The political process will always favor prominent incumbent investors."

"Invisible are the investors whose capital will flow into the new economic activity that constitutes the recovery."

"U.S. firms face exceptionally high corporate income-tax rates, the highest in the developed world at 35%, which hobbles growth and investment."

"To encourage investment, the U.S. needs to lower its corporate rates by at least 10 percentage points and reduce the incentive to escape the out-of-line and unreasonably high corporate tax rate."