The global financial crisis of 2007-2010 began with the US subprime mortgage crisis in 2007. The bursting of a hosing bubble in the country in late 2006 triggered the crisis. The subprime mortgage issue was a financial crisis marked by a sharp rise in mortgage delinquencies, foreclosures, and a large drop in capital and liquidity of many banks and other financial institutions (Hanke 2008, 10-17; Srinivasan 2005, 291-334). The financial crisis spread quickly to other sectors of the economy and other countries, thus causing the collapse of the US and European housing markets, global stock markets, global financial systems and institutions (Ryan 2008, 5-16; Cohen 2005, 9-13). Between 2008 and 2009, the United States and Europe suffered massive losses of income, jobs, wages, and wealth. In addition, corporate governance, internal policies, excessive leverage and risk taking, flawed risk models, overreliance on wholesale funding, and poor management decisions with respect to acquisitions played a major role in the global financial crisis (Lazonick 2000, 13-35; Cohen 2005, 9-13).
The Federal Reserve has adopted expansionary policies to prevent a more serious crisis from occurring. These policies include increased loans to commercial banks and low short-term interest rates. The Federal Reserve hopes that banks will increase their lending to businesses and households. On the other hand, the US treasury spent over $350 billion to bail out banks and their bondholders (Litov 2008, 1679; Baker 2010, 23). The failed firms would not have recovered from the financial crisis had it not been for the bailouts. The UK treasury has offered asset protection for financial institutions through the Asset Protection Scheme. The scheme provides government protection against future credit losses on certain assets in exchange for a fee. This in turn allows banks to continue extending loans to creditworthy businesses and households. Financial Services Authority (FSA) has also improved its effectiveness and intensity of its supervision of banks. They monitor bank activities and ensure that they remain stable and secure (Rohan 2006, 76-74; Hawley 2011, 33-37).
Whenever a projected financial meltdown jeopardizes economic growth or employment , the government finds itself under too much pressure both domestically and internationally. Bailouts are sometimes both feasible and justified on efficiency grounds. Governments bail out corporations in distress trying to maintain employment and output. However, bailouts are not always effective, are costly, and may not always bring out the desired effect. Bailouts undertaken to alleviate financial crises help in redistributing resources. Failure to bail out could lead to a prolonged economic recession that would be detrimental to everyone, but mostly to the aged, unskilled, poor and other vulnerable groups. Were it not for collapse, automobile industry would have shrunken into liquidation, which would have created chaos and vast unemployment (Anderson 2004, 68; Hawley 2011, 33-37).
If carefully chosen, bailouts can slow or even stop further economic deterioration by restoring order to markets and confidence to business investors. Notable recent example is President Obama’s bailout of GM and Chrysler automakers, which were on the verge of collapse. Obama formulated a bailout for the two companies and gave them the chance to stay in business, but imposed numerous conditions. It was hoped that the companies would secure their viability and allow the companies to eventually return to profitability. Although the federal government provided more than $80 billion in assistance, both companies had to file for bankruptcy protection by mid 2009 (Baker 2010, 23; Hawley 2011, 33-37).
Furthermore, incumbent shareholders were wiped out, board members, senior management, board members were let go, and labor bodies and dealers acknowledged significant concessions. Currently, GM is also earning healthy profits again, which allows the government to divest itself of its GM stock (Laeven 2008, 233-243; Lazonick 2000, 13-35). However, bailout systems are often perceived to reward unfairly risky behavior and negatively affect the growth of the economy. They slow down recovery by creating uncertainty, distorting market incentives, and in extreme cases, fomenting sociopolitical unrest. In addition, bailouts reduce the incentives of both firms and managers to avoid insolvency. Financing bailouts through taxation reduces profits and real wages, thus making this managerial effort inefficient (Jacobs 2004, 17; Hawley 2011, 33-37).
The US government should not bail out every distressed industry that asks it for aid. The government should be very conservative in rescuing firms. Government bailouts, which are the mainstay of economic stability, should be directed toward financial system. They include large industries, such as railroads, automobile manufacturing, and broad segments of population. Moreover, they should target only those that provide large stakeholder externalities and those that have a need for relatively modest capital infusions. The government should also presumptively eliminate existing owners and managers in bailouts. The Treasury acted accordingly when it fired both shareholders and serving managers of Chrysler and GM (Klein 2009, 185; Brown 2006, 409-434; Hanke 2008, 10-17).
Equally competent replacements must be readily available to replace those dismissed. These actions were meant to incentivize other automobile firms, such as Ford, to work hard to avoid the same fate. It is also used as a means of deterring future crises. Finally, the government should pay bailouts through taxing healthy corporations. This may be in the form of government owned debt and equity. This bailout fund approach is well-suited to mitigate the moral hazard that bailouts inevitably introduce (Hawley 2011, 233-240; Laeven 2008, 233-243; Litov 2008, 1679-1728).