Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Committing to No Bailouts (Dream On!)

Governments really dislike bailing out the financial sector when it gets into trouble: it’s expensive and deeply unpopular politically. Then why do it? The short answer is because they feel forced to. The alternative of widespread bank failures would be so catastrophic that it doesn’t bear thinking about. In principle, if the government could somehow convince the financial sector that it wouldn’t bail it out in times of crisis, this approach would reduce banks’ excessive risk-taking and substantially reduce the risk of a financial crisis and therefore the need for a government bailout.

In this section we look at these issues in more detail, including the effectiveness of policy makers’ threats not to bail out and whether they can ‘solve’ the moral hazard problem.

Making (and ignoring) incredible threats

Imagine that Barack Obama and David Cameron (perhaps their celebrity couple name would be ‘Obameron’) appear side by side at a press conference and both declare that the US and UK governments will never again bail out the financial sector and that therefore banks and other financial institutions need to take much more care in the future about the amount of risk that they take. Would this strategy successfully prevent excessive risk-taking? Probably not.

Banks would understand that even though now, in calm times, the two leaders are saying that they’ll never bail them out, they know that if banks did get into trouble, the governments would have little choice but to do so. Basically, the banks would think: they’re bluffing.

Economists formalise this idea by saying that when people bluff they’re making an incredible threat. That is, although they’re saying that they’d take one course of action in the future, if it ever came to it, they never would.


Starting the extensive form game

A useful way to model incredible threats is to use an extensive form game – a simple way of representing a strategic interaction where decision-makers take actions sequentially. Don’t worry, it’s much less complicated than it sounds! Consider the following scenario:

Banks collectively decide whether to take a moderate amount of risk or an excessive amount of risk.


If banks decide to take a moderate amount of risk, no financial crisis occurs and the game ends.


If banks decide to take an excessive amount of risk, a financial crisis occurs and the government has to decide whether to bail out the banks.

We represent this scenario as an extensive form game (see Figure 15-3).

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Figure 15-3: Extensive form game without payoffs.

At the top of the extensive form, we start with the ‘player’ who ‘moves’ first. In this case, the banks have to decide whether to take moderate or excessive risk. If they choose moderate risk, the game progresses down the left branch and no financial crisis results. No one else then has to move (no need for a government bailout) and the game ends. If, however, the banks choose excessive risk, the game progresses down the right branch. This triggers a financial crisis and the government has to decide whether to bail out or not.