What is a Government Bailout and How does it work?

                     

As the world's economy slowly recovers from the recent recession, you may have observed just how often the word “Bailout” is been used in the media. Most times it’s repeated ad nauseam as though everyone knew exactly what this is; or how it works. But a large number of people may not actually understand how it works, or even what it’s all about. That was enough reason for me to publish this post in the easiest way for all to understand – after all, what they do at the IMF affect us all.

So you want to take out a mortgage, or a loan for that business, or even get a new credit card? Well that’s fine, but you’ll be better off knowing the facts before you proceed; trust me, you might have a rethink.   

When businesses are failing i.e. becoming insolvent, or going bankrupt if you like, especially if they are big businesses that are of course very important to a nation’s economy by virtue of having a large workforce, the government don’t just watch them collapse – in fact, one could say they’re too big to fail! Imagine the amount of unemployment it could cause for that nation’s economy. What the government does is to give them a lifeline, to sort of revive them; that gives rise to what we have come to know as government bailout.

 It is however instructive to note that that it’s not just the government that can bailout a failing business – in fact, other businesses and even wealthy individuals can do so (I suppose in those cases one wouldn’t call it a government bailout). Bailouts also may or may not require reimbursement.

Why do businesses fail in the first place? Well, you’re guess is as good as mine here. There are many varied reasons companies and businesses fail and most boil down to terrible choices. Banks are notorious for this, and most often, they are the ones that end up needing these bailout funds. As you may have noticed the questions I asked earlier all have to do with services a bank would provide and these are risky ventures for their business because they are prone to default and to a large part that’s what was responsible for the economic recession a few years ago.

People take out money ‘they don’t have’ (either as mortgage, credits and so on) to buy things they can’t afford, and even sometimes what they don’t need – call it consumerism gone bad or whatever!

In actual sense, consumerism grows the economy; it’s good when people are buying. But it becomes a huge problem when they are can't pay for what they buy. And that’s where creditors (lenders) run into all kinds of trouble. When people can’t payoff their loans, when people are up to their necks in debt, maybe on student loans (as in some countries), or even credit card overdrafts, the lenders [banks] begin to panic because they’re running low on cash. They may foreclose the properties of defaulters or turn to those collateral they presented in an attempt to sell them and spin some cash; but it’s not that automatic—with a struggling economy, not many people can afford those stuff they put up for sell. With time these creditors may go bankrupt.

So how exactly does a bailout work? The idea here is for the rescuer (government, company, individual) to ‘buy’ up the debt; now, what this means is the rescuer pays the failing business the money the debtors owe it (in the case of creditors)—all the money it should have made had the borrowers not defaulted is injected into their coffers. That money is the Bailout fund.

In the case of a government bailout, does the government order the treasury to print money and pay these embattled businesses? Although it may choose to do that if it wishes, the government knows that it would cause inflation which would hurt the economy even more, so it doesn’t just print more money. One way it garners the bailout fund (apart from other series of legislation which constitute the entire bailout package) is by setting up government bonds whereby people literally lend the government money by investing in these bonds for which they’ll be paid interest on. This fund is used by the government to bailout the failing business.

Bailouts could also be in the form of stocks, or loans.

Are there real cases of Bailouts? It is all the more obvious these days to notice one going on. I’ve so far only mentioned businesses as needing bailouts, but even countries do (Greece and Spain being very recent examples)—and it’s not hard to imagine if you just think of  those countries as big businesses gone bad, in which case International organizations and Confederations can come to their aid.

So there you have it! Bailout explained in lay terms. Next time it’s mentioned, you wouldn’t look so ignorant.

Fancy word you might wanna know about:

Credit Crunch: This explains the situation whereby banks and other lenders suddenly don’t have money to lend—or so it would seem since lenders are scared of defaults and they too going into bankruptcy. They up their interest rates, tighten their conditions, making it highly unfavourable for failing businesses to borrow during a recession.

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