Bailouts without new rules can only end in more tears

Institutions considered too big to fail in the financial crisis were given taxpayer money, a lot of finger wagging and no meaningful re-regulation. More boom and doom awaits.

Greek protestors demonstrate in Athens. The IMF led a bailout for the country to prevent the financial crisis from spreading in Europe.
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WASHINGTON // Informed opinion is sharply divided on how the next 12 months will play out for the global economy. Those focused on emerging markets emphasise accelerating growth, with some forecasts projecting a 5 per cent increase in world output.

Others concerned about problems in Europe and the US remain more pessimistic with growth projections closer to 4 per cent, and some are even inclined to see a possible "double dip" recession. This is an interesting debate but it misses the bigger picture. In response to the crisis that ran from 2007 to last year, governments in most industrialised countries put in place some of the most generous bailouts ever seen for large financial institutions.

Of course, it is not politically correct to call them bailouts. The preferred language of policymakers is "liquidity support" or "systemic protection". But it amounts to essentially the same thing. When the chips were down, the most powerful governments in the world (on paper, at least) deferred again and again to the needs and wishes of people who had lent money to big banks. In each instance the logic was impeccable. If the US hadn't provided essentially unconditional support to Citigroup in 2008 and last year, the resulting financial collapse would have deepened the global recession and worsened job losses around the world.

Similarly, if the euro zone had not stepped in, with the help of the IMF, to protect Greece and its creditors we would have faced further financial distress in Europe and perhaps more broadly. And it worked in the sense that we are now experiencing an economic recovery, albeit one with a disappointingly slow employment rebound in the US and some European countries. So what is the problem with the policies of the two years of crisis and why can't we just plan on doing something similar if we face a crisis of this nature again?

The problem is incentives - what bailouts imply. If you are "big" in relation to the system, you are more likely to get generous government support when there is system-wide vulnerability. How big is "big enough" remains an open and interesting question. Major hedge funds are presumably looking for ways to become bigger and take on "systemic importance". If all goes well, these hedge funds, and of course the banks that are already undoubtedly too big to fail, get a great deal of upside.

If anything goes wrong, everyone who is too big to fail, or has lent to such companies, expects government protection. This expectation lowers the cost of credit for major banks today (compared with their competitors that are small and more likely to be allowed to fail). As a result, all financial institutions gain a powerful incentive to bulk up. Top US policymakers acknowledge that this structure of incentives is a problem.

But the rhetoric from the White House and the Treasury department is "we have ended too big to fail" with financial reform legislation before Congress and likely to be signed by Barack Obama, the US president, within a month. Unfortunately, this is simply not the case. On excessive bank size and what it implies for systemic risk, there was a concerted effort by the senators Ted Kaufman and Sherrod Brown to impose a size cap on the largest banks, very much in accordance with the spirit of the original "Volcker Rule" proposed last January by Mr Obama.

In an almost unbelievable about face, for reasons that remain somewhat mysterious, that Mr Obama's administration shot down this approach. Whether the world economy grows now at 4 per cent or 5 per cent matters, but it does not much affect our medium-term prospects. The US financial sector received an unconditional bailout and is not now facing any kind of meaningful re-regulation. We are setting ourselves up, without question, for another boom based on excessive and reckless risk-taking at the heart of the world's financial system.

This can end only one way: badly. Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan and a senior fellow at the Peterson Institute for International Economics * Project Syndicate