Inside Money: When good guarantees turn bad

Professor Edward Kane. Photo / Supplied

Kudos to the Reserve Bank for publishing this paper in 2005 when just about nobody else was contemplating financial disaster.

The paper Containing a Systemic Crisis: Relicensing vs Blanket Guarantees authored by Edward Kane (with Daniela Klingebiel) was written in boom times and probably widely ignored. I must confess that until last night I was unaware of its existence.

But, as the nation contemplates the possibility of a billion or so dollar bailout of South Canterbury Finance (SCF) deposit holders, the Kane/Klingebiel deserves to be revisited, if only for historical interest purposes.

"Commonsense analysis," Kane wrote in 2005, "indicates that policy actions taken at the outset to contain a developing crisis- particularly the issuance of extensive liquidity support and government guarantees-absorb off-budget fiscal resources and tend to inappropriately constrain policy options for dealing with insolvent institutions in the later phases."

Which brings us to 2010 and Bill English's decision to cancel his offshore jaunt and deal with the later phases of a government deposit guarantee scheme. Most likely he will have to oversee the socialising of losses as taxpayers pick up the SCF shortfall - as per our previous promise to ourselves.

But if someone had read the Kane paper sometime before this crisis enveloped us they would've learnt that:

• Blanket guarantees add substantially to fiscal costs of crises

• They are not necessarily successful in restoring public confidence

• And they add little to the recovery process

• Therefore indiscriminate guarantees should be avoided

We'll remember that next time.

Or maybe not because, as Kane points out: "Once blanket guarantees have been employed, it is hard to convince the public that guarantees won't be renewed at the first sign of another panic."