International Bailout Arms Race

In an opinion piece in Tuesday's Wall Street Journal, Federal Reserve Chairman Ben Bernanke found it "heartening that we are seeing not just a national response but a global response to the crisis, commensurate with its global nature." In contrast, I see the current flash of national bailout news conferences as evidence of an international bailout arms race.
The precipitous decline in financial markets last week, in spite of the passage of the $700 billion bailout package in the U.S. and coordinated interest rate reductions by central banks across the globe, raised many questions as to whether the policy responses were not enough, too much, or too late. My response is that the U.S. bailout and the Fed's interest rate reductions were correct for the United States, but that the response by the rest of the world was not enough given the global scale of the financial crisis. This was evidenced by the stabilization of markets this week as virtually every developed country in the world announced a bailout package over the weekend similar to that of the U.S. Now the question is whether the U.S. economy will retain its dominant status in the world economy.

In my previous post about the causes of the financial crisis, I detailed how this was predominantly a problem that originated with bad policy in the U.S. and was subsequently exported around the world thanks to clever financial engineering, some overly optimistic ratings by S&P and Moody's, and some degree of international investors ignoring questions about the level of risk they faced. The declines in financial markets reflected the reality that a significant proportion of the mortgage backed securities that caused this problem were held outside of the reach of the U.S. bailout package. They are held in large supply by foreign corporations, banks, money market funds, insurance companies, and even governments. And until nearly every other developed country committed to a financial bailout last weekend similar to that passed in the U.S., financial markets would stabilize.

Imagine the hypothetical case in which the U.S. is the only country to quarantine its supply and exposure to the toxic mortgage backed securities. This would give existing U.S. firms and banks a relative advantage over their foreign counterparts, thereby increasing U.S. profits and market share. Given the bailout package passed in the U.S., the best response for foreign countries is to pass their own bailout packages so as not to let their native firms and banks lose ground in the international market place.

What we are seeing now is starting to look a lot like the nuclear arms race of the 1980s, a poker game in which Russia eventually folded. In the case of the current international bailout arms race, it looks like Iceland will be the first country to throw in its cards. Iceland's exposure to mortgage backed securities was more than the government could credibly cover. In the middle of this week, the Krona stopped trading altogether on international currency markets, and Iceland has had to ask for emergency foreign aid from countries like Russia. Hungary seems to be the next country on the verge of leaving the bailout table as its exposure to the crisis has elicited aid from the European Central Bank. Keep in mind that this is the first time that the ECB has ever lent money to a non-member country.

Additional uncertainty in the bailout poker game comes from the big countries ability to pay for their proposed packages. Germany's bailout package is estimated to take their debt-to-GDP ratio from its current level of around 55% to above 75%.  U.S. debt-to-GDP is currently around 65% and will certainly rise with the implementation of our proposed bailout package. The immediate question is whether the countries that have said that they are in the bailout game, will be able back up their commitment.

The long-term question is how the financial crisis and insipient bailout arms race will affect countries' relative economic positions. Ironically, the U.S., the country who exported this problem around the world, is currently the safe-haven investment destination in the world. The dollar has appreciated against other major currencies over the last few days, and Treasury bonds prices have risen on increased demand.

However, the U.S. position in the long-run, and that of any other country, will depend on its ability to pay for its respective bailout (not to mention how the bailout is structured and implemented). This seems to be an advantage to the U.S. in the long run, as we seem to be in a better position than most countries.

On the other hand, I see a long-run negative effect on the United States as foreign countries will be more wary of dollar denominated assets. Fool me once, shame on you. Fool me twice, shame on me. Even before the current financial crisis, the dollar's role as the international currency of choice was being challenged by the Euro. Now, loss of confidence in U.S. ratings agencies, financial instruments, and government policy will likely further incentivize foreign investors to diversify away from U.S. investment.

It is nice to win an arms race as long as you don't mind alienating the opponent country. In the case of an international bailout arms race, our economy depends on the very countries that we are pitted against.