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Expert: ‘Bail-ins’ exacerbate market bubbles by making economy more cyclical

Amitai Aviram
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L. Brian Stauffer

Law professor Amitai Aviram argues that “bail-ins” amplify the highs and lows of future business cycles and undermine the policy goals of those who believe free markets allocate investments optimally, as well as those who prefer government guidance in allocating investments.

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1/5/2012 | Phil Ciciora, Business & Law Editor | 217-333-2177; pciciora@illinois.edu

CHAMPAIGN, Ill. – In the wake of financial crises, governments that wish to assist crisis victims must choose between publicly financed bailouts and “bail-ins,” which use the law to retroactively modify agreements in favor of victims so that private resources support the victims. While bail-ins are politically appealing and may seem fair, a University of Illinois business and law expert argues that they amplify the highs and lows of future business cycles and undermine the policy goals of those who believe free markets allocate investments optimally, as well as those who prefer government guidance in allocating investments.

Amitai Aviram, a professor of law and the Lynn H. Murray Faculty Scholar in the College of Law, says that while traditional analysis of bail-ins assumes that they permanently reduce future investment, their effect on investment, in fact, likely fluctuates over time as a result of both cognitive biases and rational incentives of business executives.

According to the article, published in the University of Illinois Law Review, investments decline as an immediate reaction to a bail-in, but then gradually increase until the effect of the bail-in on investment becomes nearly negligible by the time the next economic boom begins.

“While a fluctuating reduction in investment sounds better than a permanent reduction, it actually causes greater harm and is more difficult to offset through other policies,” Aviram said. “Bail-ins exacerbate the shortage in investment during busts without lessening excessive investment during booms, making the economy more cyclical than it would otherwise be.”

A bail-in is essentially “using the law to force a private bailout,” Aviram says.

“It is a common response to a financial crisis. In the wake of such crises, public authorities often use the law to modify private contracts, transferring value from those who fare better in the crisis to those who fare worse. From the perspective of the crisis victim, this is a bailout. But I call it a ‘bail-in’ because a bailout implies using public funds.”

Recent examples of bail-ins include staying foreclosures, authorizing bankruptcy courts to modify mortgage terms, or threatening criminal prosecution to induce banks to undo transactions made with their clients. According to Aviram, bail-ins have greater political appeal than other forms of redistributive government action, such as increased government spending and taxation.

“Bail-ins are common because of the incentives for the politicians sponsoring them,” he said. “There’s no threat of new taxes or a larger deficit, and usually no salient price tag the media can focus on, since government isn’t writing a check but making boring, technical tweaks to private contracts.”

Because the effect of bail-ins is thought to be a permanent reduction in investment, resistance to such measures tends to be light: Market-skeptics applaud them as a way to reduce the previous boom’s excesses, while market-trusters tolerate them since they believe the harm bail-ins cause is easily corrected with a corresponding subsidy to encourage investment. But Aviram’s paper suggests that bail-ins should raise red flags for adherents of both camps.

“The market-skeptic argument for bail-ins is that the market tends to go in manic-depressive phases, and in the mania phase, there is too much investment; for example, too many mortgages going to people who can’t repay,” he said. “To the market-skeptic, the fact that bail-ins deter investment is a good thing because it prevents the excesses of the next boom.”

But because the investment-deterring effect of a bail-in will peter out by the time the next boom arrives, all it will deter is investment during the bust, when investment is already scarce, Aviram said.

“On the other side of the ideological spectrum, market-trusters do not like that bail-ins deter investment that would have occurred in a free market, but their concern can be assuaged by an offsetting government subsidy that encourages investment,” he said. “For example, if banks expect that once the housing market turns sour, government will make it difficult to foreclose, they might lend less. But if government offers a tax deduction for the interest paid on mortgages, that would lower the cost of a mortgage and encourage more lending, potentially offsetting the effect of the bail-in.”

But because the effect of bail-ins on investment diminishes over time, Aviram contends that such a subsidy sows the seeds of the next bubble.

“The subsidy will, perhaps, offset the effect of the bail-in during the bust, but it will still be there after the bail-in’s effect dissipates, artificially increasing investment during the boom,” he said. “Therefore, a subsidy that market-trusters hoped would bring investment closer to the free market level would, instead, artificially inflate investment in future booms.”

This doesn’t mean that we never want to have government interventions, or that we never want to have interventions where the private sector picks up the bill, he said.

“Financial crises are, to my mind, inevitable,” Aviram said. “They’re going to happen no matter what we do, and all government can do is choose whether they happen less frequently but more severely, or more frequently but less severely.”

“There are tradeoffs between relying more on free markets and relying more on government intervention,” he said. “Neither offers a free lunch, and the decision on what is the optimal tradeoff for society at any given time is ultimately an ideological one, addressed through the political process.”

But because of the political appeal of bail-ins, greater scrutiny is warranted.

“Because we mistakenly assume that bail-ins’ effects on investment are permanent, we underestimate their cost,” Aviram said.

Editor's notes: To contact Amitai Aviram, call 217-244-1668; email aviram@illinois.edu.

The paper is available online.

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