The Staggering Fiscal Costs of Bailing Out a Financial System in Crisis

In his February 27th column in the Financial Times Martin Wolf considers further my “12 steps scenario to a systemic financial crisis” that he had very thoughtfully presented in his previous column.

In the new column Wolf makes a series of interesting points. First he argues that my “analysis suggested a highly plausible worst case scenario, not the single most likely outcome”. Second, he argues that, even in this worst case scenarios, the expected losses for the financial system (that I estimated to be about $1 trillion) and thus the potential fiscal costs of a bailout of the financial system would be only 7% of GDP, an amount that a large economy such as the US can easily afford: as he argues the US public debt would increase in that scenario only to 70% of GDP. And the yearly costs of servicing such increased debt would be – in his view – “a mere 0.2% of GDP in perpetuity.  This is a fiscal bagatelle”. 

What should we make of his argument? For now I will not debate whether my scenario is plausible or not; let us leave aside this debate for now and let us concentrate on the fiscal costs of a bailout of the financial system in this “worst case scenario”.  Will it be only 7% of GDP or more? I will argue in this article that such fiscal costs of a financial crisis could be much higher than 7% of GDP, as high as 19%, even leaving aside the even bigger losses in the net worth of the private sector that a severe financial crisis would imply.

Here are a number of reasons why the overall financial losses and the fiscal costs of a bailout of the financial system could be much higher than 7% of GDP…