The collapse of global trade, murky protectionism, and the crisis:

16. Bailouts: how to discourage a subsidies
war
Simon J. Evenett and Frédéric Jenny
University of St Gallen and CEPR; ESSEC and Cour de
Cassation
During the current global economic crisis many governments in industrialised countries
have shied away from blatant protectionist measures, such as raising tariffs and
imposing quotas, and have instead offered "bailout" packages involving considerable
sums of state funds and guarantees to the banking, insurance, and automobile sectors,
to name a few. In part, this reflects the drying up of credit offered by traditional
financial intermediaries to each other and to the rest of the private sector. As the
crisis has deepened, however, the rationale for these bailouts has shifted from the
preservation of the payments system (an economy-wide matter) to sectoral initiatives
targeting jobs loss and the viability of selected firms. Doubt is cast here on the wisdom
of this shift, especially as the discriminatory impact (if not intent) of these
bailouts could trigger a wasteful subsidies war between governments.
The systemic purpose of the initial bailouts
In the past 12 months bailouts have implemented for two reasons. First, the sheer
magnitude of the total losses from holding mortgage-backed assets (estimated to be
of the order of five trillion dollars) and other financial instruments has created concerns
about counter-party repayment risk and bank insolvency. So as to prevent runs
by bank depositors, that could ultimately jeopardise the viability of the national payment
systems upon which monetary economies survive, a compelling case was made
for offering financial support to banks.
Second, the destruction of wealth in the financial sector has also hurt the real
economy. The decrease in stock values and falling house prices have reduced expenditures
by investors and retirees who live off their stock and bond portfolios. Banks
with weak balance sheets and financial institutions have less working capital to lend.
This further affected the real economy by reducing consumer purchases of goods and
services, and investments by firms that use credit to finance their expansions.
Furthermore, increased uncertainty about the future (in particular concerning the
prospect of being unemployed) generated a fall in spending for risk-averse consumers
and investors. Taken together these effects have systemic implications. Many firms
have found themselves facing a double squeeze; on their sales and on sources of working
capital. Consequently, pressures to lay-off employees and cut investment levels
have intensified. In these circumstances governments cannot be realistically expected
to confine bailouts to the banks when other large firms face bankruptcy and unemployment
queues lengthen.
So it came to pass that governments, through separate interventions and in stimulus
packages, have offered subsidies to banks and commercial firms. These subsidies
have taken many forms. For example, some have consisted of direct payments to
81