Does the Government Need Financial Bailout Insurance?

Posted July 20, 2009 at 1:56pm

I have come to the conclusion that the federal government needs to have some type of insurance for financial bailouts.

[IMGCAP(1)]We now know that a financial meltdown has the potential to be costly and that the effect on the budget will be painful and long-lasting. Waiting until a financial disaster occurs to figure out how to pay for a bailout leaves the government largely unprepared to do so. In addition, if, like now, the meltdown occurs when the deficit and federal borrowing are already high, the situation is even more complicated.

So, in much the same way that insurance makes sense for someone who can’t afford to lose the use of his car, why shouldn’t the federal budget include financial bailout coverage for the economy?

“Insurance— is not a word used much in federal budget circles. The reason is the deficit, which makes it much harder for government to do some things that it should do. I’m not talking about major policy expansions for health care or the military; I mean activities that protect against the costs of catastrophes.

In fact, in most cases the federal government doesn’t have insurance. Instead, using a wonderful phrase that means the exact opposite of what it implies, the government is largely “self-insured— — that is, there is no insurance and the government has to bear the full cost of a disaster when it occurs.

This delusional hope and budget projections are based on the notion that a tornado, fire, earthquake, hurricane, war or economic calamity will never happen. But when they do, taxpayers are immediately on the hook and the federal budget outlook instantly gets much worse.

The truth, however, is that the liabilities were always there and the likely higher deficits just weren’t recognized.

The real benefit of federal self-insurance (the term means something completely different in the private sector) is that, because no funds are spent or set aside until they are actually needed, Congress and the White House in the meantime don’t have to raise taxes or reduce other spending because the deficit appears lower than it would otherwise be. Those decisions only have to be faced when a disaster occurs and coverage of the event (think of the pictures from New Orleans after Hurricane Katrina) makes increasing the deficit much easier.

President George W. Bush, for example, was able to go to New Orleans after Katrina and make a nationally televised address saying the government would spend billions to rebuild the city, and Congress then quickly agreed to the funds. Prior to the hurricane, this almost certainly wouldn’t have happened even though there was a good chance that one or more colossal natural disasters would occur somewhere.

Financial disasters like the ones we have had over the past few years are different from most natural disasters because they affect far more than those in the immediate area. This is not to say that the individuals and communities affected by an earthquake, tornado or flood aren’t devastated. But a financial meltdown by even one large institution clearly has the potential to affect the U.S. as a whole and, therefore, to cost far more than all natural disasters other than those of biblical proportions. It’s this systemic risk to the economy that demands the federal government think about insurance.

Some very difficult questions would have to be answered before this insurance could be put in place. For example, how could we determine the actual risk of a future financial meltdown and who should make that determination? How often would or should that risk be reassessed?

But the risk assessment might be relatively easy compared to the question of who should pay the premiums for bailout insurance.

On the one hand, it’s easy to say that the financial institutions whose actions would likely cause a meltdown and trigger the bailout should pay. This would be similar to an auto leasing company requiring that the driver of one of the cars that it leases have insurance. Although the leasing company stands to lose if the car is totaled and the driver can’t pay to have it fixed, the driver’s actions will be the one that causes the damage.

On the other hand, because the economy as a whole is what needs to be protected and, therefore, insured, an argument can easily be made that the premiums for bailout insurance should be paid by taxpayers rather than financial institutions. This would be the equivalent of the auto leasing company paying for insurance against its business being disrupted by one large event (like a fire in its garage that affects a number of vehicles) or a number of smaller accidents happening at the same time.

Regardless of who pays, the other big budget issue is what should be done with the premiums that the government collects each year. Putting them in a federal trust fund that has to be invested in Treasury securities means that, like Social Security, the money would simply be lent back to the federal government and used for other purposes. Investing the funds on Wall Street would mean that value of the premiums could be greatly reduced by the meltdowns that they were collected to insure against. Leaving the premiums uninvested in a vault at Fort Knox would mean that they would lose value relative to inflation. There would also almost always be the temptation to use the funds for other purposes or to cut the premium when the economy was doing well and a meltdown seemed less likely.

But all of these questions are really beside the point.

If systemic risk caused by financial institutions can’t really be avoided, another meltdown, substantial federal spending and increased deficits and national debt to deal with it are almost absolutely assured regardless of who is president and which party is in control of Congress. That makes bailout insurance the best way to make sure that the short- and long-term damage to the budget is much less than it would otherwise be.

Stan Collender is a partner at Qorvis Communications and author of “The Guide to the Federal Budget.— His blog is Capital Gains and Games.