My friend Vern McKinley, a lawyer who specializes in central banks, has co-authored a new paper from Cato, arguing that there are no bright lines for deciding when a bank bailout is good policy:

The turmoil after the Lehman Brothers failure is not so much an argument for intervention in that case, but rather an indicator of the impossibility of implementing a clear bright-line rule for bailouts. Efforts to distinguish a bright line between Bear Stearns and Lehman Brothers, and the lack of a consistent policy coupled with the multiple efforts to address the crisis, contributed to the angst visited upon market participants during 2008 and 2009. Even with the economic analysis resources at its disposal, the Federal Reserve has been unable to reliably predict contagion or judge an appropriate timing or level of intervention. Like the FDIC, the Federal Reserve has also been opaque with regard to the precise institution-specific reasons for intervention, which is seemingly at odds with Chairman Bernanke�s historical emphasis on transparency regarding central bank policy.

I read a draft of this paper that Vern sent, and liked the focus on "clear evidence of contagion" for bailouts. (I think he and I agree less on whether there was clear evidence last September, but clarifying the criteria is useful.) It is not, as they say in the introduction,

...that the failure of an institution will impose losses on a broad array of creditors, shareholders, and counterparties, or that it will present a challenging or difficult receivership or bankruptcy process to work through. Even if a standard can be articulated, it is another matter to successfully implement that standard in practice. We believe that the lack of a clear standard and the shifting efforts at implementation have exacerbated the current financial turmoil by sending confusing and inconsistent signals to market participants.

There is still the problem of convincing angry taxpayers and their supporters on Capitol Hill that contagion is a clear and present danger (if it does exist.) Those that try tend to get no thanks for their efforts, but I would prefer that those who see contagion work harder to make the case than telling the naysayers like Malkin to just shut up. As McKinley and Gegenheimer argue, that case isn't easy even for experts.

As I get closer to teaching money and banking next month, I'll focus on more of these papers. This one will be on the course reading list, which I will post (I'm in fact going to replicate my 2005 intro to econ series -- example -- with the lectures from this one -- this time maybe with sound and video??) Suggestions for additional readings invited in comments.

Labels: banking, economics