It's time to get the bailout bandwagon rolling smoothly... Businesses' survival depends on it. And whenever governments have pitched in to help out, they have got their returns... in most instances. Image Credit: AP

In 1971, capitalism changed forever in the US - and in the rest of the world - when a specific industrial firm was bailed out. That company was Lockheed Aircraft Corporation, and the bailout was in the form of loan guarantees and subsequent equity injections totaling $250 million.

Prior to this, the US had never acted in “loco parentis” for any single firm. Subsequent bailouts followed, in the form of Penn Central Railroad and Chrysler Corp., which led to a culture that permeated throughout the economy with increasing magnitude.

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In each case, the logic was simple: the companies in question were undercapitalized - whether due to excessive leverage, financial mismanagement, exogenous economic shocks or some combination of all - and failure to rescue would culminate in job losses and capital destruction. As the pace of economic bailouts increased, it was feasible for those countries that had the ability to indulge in quantitative easing.

But the philosophical question remains: Have the bailouts worked?

Got their returns

The investigative challenge for the above query unfortunately does not allow us to examine counter-factual outcomes had governments not intervened in the private markets. Without this knowledge, all that can be examined is whether these bailouts yielded a net surplus to the taxpayers.

In the overwhelming majority of cases, that answer has been positive. Over a 10-year horizon, tax payers in the US received a weighted average net return of 4-6 per cent, despite there being many instances of the same companies returning for further bailouts.

Does this imply that bailouts are part and parcel of capitalism? That even for countries that do not have the luxury of printing their way out, resources must be allocated to the private sector, leading the government to be a de facto fund manager?

A permanent backstop

Is it in the nature of private sector enterprise to be undercapitalized, and without these bailouts, the losses will be too gargantuan for society as a large to recover from? Further, is there an obvious moral hazard that encourages excessive risk taking on the part of the private sector, knowing that there is always going to be some sort of relief offered when things go wrong?

Relying on the self interest of individuals (which is the fundamental cornerstone of capitalism) by definition implies that regardless of regulatory oversight, there will be sectors that will not be able to cope with exogenous economic shocks, such as the one that we are facing. Given this, the only choice available is either for society to withstand some amount of pain, as companies shrink and die, with others replacing it in due course. Or to allow for some criteria under which bailouts are mandated.

Balance out eventually

These then can be followed by increasingly higher capital requirements such that the financial system emerges stronger. But regulators have to be resigned to the idea that in a world of increasing financialization, the amount and frequency of such bailouts will continually increase to a point where the underlying capital base is sufficient enough such that economic growth rates outstrip the cost of debt.

In Latin, we call that res ipsa loquitor (the thing speaks for itself). Governments have already created sovereign wealth funds in many cases, and although the primary reason has been to diversify the risks they face endogenously, there has been increasing exposure to domestic economies as allocating funds to these companies has had a positive financial track record, in addition to social benefits.

There can be no situation where pain is altogether avoided. For any prudent government looking to allocate, the decisions must weigh the financial impact (return on capital) alongside the goals of maximizing employment and maintaining price stability. Allocate too liberally, and the demon-haunted world of inflation rears its ugly head; allocate too little or none at all (a la Japan in the 1990s), and the economy gets trapped into the vice of debt-deflation.

As the UAE looks to allocate further incentives to stabilize and stimulate the economy, the funambulistic exercise that it must indulge in is a challenge that is certainly not enviable. History, however, offers some solace - both in the track record of bailouts conducted in advanced economies, as well as the country’s own stewardship, which has continually managed choppy waters in an admirable and bold fashion.

Current times call for no less of a backdown. The nature of the world economy, however is one, where increasingly the bailout toolkit is a standard part of the armory to fend off economic stagnation.

- Sameer Lakhani is Managing Director of Global Capital Partners.