My view is that no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers—for the best of reasons—to bail out financial firms. In other words, no legislation can completely eliminate bailouts...
So, that’s my first point: Bailouts are inevitable during financial crises. Let me move to the second: Anticipation of bailouts creates inefficiency in the allocation of real investment...
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As in the pollution case, using taxes to discourage excessive risk saves the government from actually trying to solve the cost-minimization problem of financial firms...
Here’s what I have in mind. Suppose that, for every relevant financial institution, the government issues a “rescue bond.” The rescue bond pays a variable coupon equal to 1/1,000 of the transfers made from the taxpayer to the institution or its stakeholders. (I pick 1/1,000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero, because bailouts aren’t necessary and so the firm will not receive transfers. However, just like the institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In a well-functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the firm and its stakeholders. Thus, the government should charge the financial firm a tax equal to 1,000 times the price of the bond. Note that the “rescue” bond is only a measurement device. In particular, it is not part of the financial firm’s rescue.
Notice that this approach could be used for a wide variety of financial institutions, including nonbanks. In principle, the government need not figure out in advance exactly which are systemically important and which are not. Instead, it could simply issue a rescue bond for every institution. Then the market itself could reveal how systemically important each institution is through the price of its rescue bonds. Of course, markets are not always perfect. It may not always be appropriate to rely only on market measures to compute the appropriate taxes. However, even in these cases, the prices of rescue bonds would contain valuable information that should be an important input into the supervisory process.