How The Frank-Dodd Act Reframes Bailouts

Robert Shiller describes how the Frank-Dodd Act reframes future bailouts as "orderly resolutions" to work around the widespread unpopularity and negative perceptions of financial bailouts. Mark Thoma agrees that the perception should be that the banks are paying for the bailout themselves and that certain individuals are not protected from losses. See the following post from Economist's View.

I don't always agree with Robert Shiller's touchy-feely approach to economics, but he might have a point here:

Bailouts, Reframed as ‘Orderly Resolutions’, by Robert Shiller, Commentary, NY Times: Distasteful as it may seem, we need to prepare for the next financial crisis, which, of course, will arrive eventually. Right now, though, people are so angry about the recent bailouts of Wall Street that the government may not be able to use the same playbook again.

The criticism has emphasized the trillions of taxpayer dollars that the bailouts put at risk. But, in fact, the realized losses were minuscule when compared with the widespread suffering they averted. ... TARP may have prevented many trillions of dollars of losses in gross domestic product.

Our principal hope for dealing with the next big crisis is the Dodd-Frank Act... It calls for bailouts of a sort, but has reframed them so they may look better to taxpayers. Now they will be called “orderly resolutions.” Psychologists tell us that subtle changes in framing ... can bring major changes in perception. ...

In essence, Dodd-Frank is asking the F.D.I.C. to do much the same thing for a wide spectrum of financial companies as it has done with traditional banks. ...

The Dodd-Frank Act acknowledges that when the F.D.I.C. moves into deals like this with financial companies, it may need some assistance. So the law creates an Orderly Liquidation Fund at the Treasury, which can issue debt for it as needed. Of course, that could be interpreted as a bailout that uses taxpayers’ money, since the debt has to be repaid somehow.

But here’s the reframing: The Dodd-Frank Act specifies that the F.D.I.C. will be paid back through “assessments” on financial companies. These assessments won’t be paid immediately... The Treasury can intervene first and be repaid later.

This is a classic and potentially effective reframing. Why? The payments are called “assessments,” not taxes. And the context has changed, with the burden appearing to fall squarely on Wall Street, and not on taxpayers.

Of course, reframing won’t convince everyone that the government’s interventions are benign. In fact, an assessment is much the same thing as a tax... Ultimately,... this tax is really paid by the public, because those financial companies are owned by thousands upon thousands of individuals...

The general taxpaying public may never figure out the true effect of ... the tax... But many people have acquired a sense of suspicion that anything that looks remotely like government largess will show up in higher taxes someday. That is part of the reason for the rise of the Tea Party movement, and was a factor in the recent midterm elections.

Still, well-thought-out framing packages can work. They can help sell crucial intervention packages to people who don’t fully understand the financial system’s complexities or how government interventions prevent disasters.

Unemployment ... certainly would be much higher had the government not embarked on bailouts. We have to hope that the Dodd-Frank reframing succeeds — and that taxpayer anger doesn’t scare the government away from following the law’s intent aggressively. Such timidity could allow more Lehman-type failures.

The framing of the Orderly Liquidation Authority might be regarded as a form of diplomacy, needed to avoid unwanted anxieties that could prevent the Treasury and the F.D.I.C. from taking strong action to support our financial system.

This is vitally important. We avoided a depression in 2008 and 2009, and we need to do so again when the next crisis arrives.

I think this may miss something about the public's anger. Since the government didn't have resolution authority for banks in the shadow system, it only had two choices when faced with the collapse of a large bank like Bear Stearns or Lehman. Let the bank fail and risk a domino effect that brings the entire system down and potentially creates a depression, or bail out the systemically important bank -- including management and equity holders (investors). [Some claim the government did, in fact, have other choices, but I don't think the key players in the Fed and Treasury believed that they had the authority they needed to take over the large banks, remove management, and put them through traditional FDIC-like procedures that impose losses on investors.] By choosing to bail out the banks, they also bailed out those who created the mess. This left the appearance that the wealthy and well-connected get bailed out, while the middle and lower classes get the bill. Typical households really can't see what they gained from the bailout since, for many, the counterfactual where the system melts down without a bailout is either hard to imagine or not believed. They don't understand, for example, why the government helping them to pay off loans wouldn't have helped banks just as much as a direct bailout. "Where was my bailout?" they wonder.

I am not sure that the government will have the courage to use the Orderly Liquidation Authority when the next big crisis hits. This is not something that has ever been tested, it does not prevent runs on the shadow banking system, and if regulators announce such a procedure only to see financial markets beginning to implode with worry, they may resort to a more traditional bailout despite public opposition to it. But assuming they do use the new authority, I agree it's important that the banks appear to be bailing out themselves, though I would have them prepay into a fund rather than pay it all after the fact. But I think it's even more important that, however the bailout is done, we remove the perception that the well-connected are protected by a "Greenspan-Bernanke Put" that prevents them from taking big losses whenever the system gets in trouble.

This post has been republished from Mark Thoma's blog, Economist's View.