Can a Strong Central Government Credibly Commit Not to Intervene?

24 October 2011 at 10:18 am 4 comments

| Peter Klein |

When the subject is large financial or industrial companies, the answer is clearly no. Government promises not to rescue failing banks or large firms are cheap talk, not credible commitments. A central government strong enough to bail out politically connected organizations will bail them out; the only government that can credibly commit not to intervene is one that is not legally empowered to intervene. And no modern state is willing to give up that discretionary authority. Here is evidence from Korea:

Ending “Too Big To Fail”: Government Promises vs. Investor Perceptions
Todd A. Gormley, Simon Johnson, Changyong Rhee
NBER Working Paper No. 17518, October 2011

Can a government credibly promise not to bailout firms whose failure would have major negative systemic consequences? Our analysis of Korea’s 1997-99 crisis, suggests an answer: No. Despite a general “no bailout” policy during the crisis, the largest Korean corporate groups (chaebol) – facing severe financial and governance problems – could still borrow heavily from households through issuing bonds at prices implying very low expected default risk. The evidence suggests “too big to fail” beliefs were not eliminated by government promises, presumably because investors believed that this policy was not time consistent. Subsequent government handling of potential and actual defaults by Daewoo and Hyundai confirmed the market view that creditors would be protected.

Entry filed under: - Klein -, Bailout / Financial Crisis, Business/Economic History, Myths and Realities, Public Policy / Political Economy.

Papers of Interest from the NSF’s Call for Long-Term Research Agendas CFP: “Managing Wicked Problems: The Role of Multi-Stakeholder Engagements”

4 Comments Add your own

  • 1. Mathieu Bédard  |  25 October 2011 at 9:40 am

    So would it be correct to say that the only “constructive ambiguity” left is over which firm is Too Big to Fail and which is not?

  • 2. papi  |  27 October 2011 at 3:17 pm

    So there are 2 constituencies in banks – shareholders and management. Nationalization at least seems to credibly threaten the latter, if not the former. ‘Course, you could also offer to prosecute (for fraud) management. At minimum this sets up an agency conflict where management sabotages shareholder preferences for high risk.

  • 3. Michael E. Marotta  |  27 October 2011 at 5:09 pm

    Then there is the definition of a “strong” central government. A government of limited constitutional powers can be much stronger (more stable) than one claiming absolute power and total rule… until the next coup d’etat, or at least a vote of no-confidence.

    Governments have been bailing out big investments since the Dutch and the English in the early to late 1600s. In America, the habit was established a bit later; we followed Andrew Jackson’s lead for over 100 years.

    As a numismatist – numismatics provides the evidence to validate economics – I can point several ad hoc remedies, such as the Clearinghouse Scrip of 1907, that did not involve government bailouts.

    Everyone gets upset when banks fail. The passing of Borders Books did not draw the same reaction. Of course, what would the Federal remedy have been, big “loans” from the Library of Congress?

  • 4. Robert Higgs  |  21 November 2011 at 3:52 pm

    In modern political economies (all of which are forms of economic fascism), the big firms and the central government are, in substance if not in a technical, legal sense, the same thing: they are run by the same people, passing back and forth through the revolving doors. To say that the government won’t bail out the big firms is to say that the government won’t save itself, which truly is not credible.

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