The Problem With ‘Nationalization’

Posted: February 28th, 2009 by Militant Libertarian

by GERALD P. O’DRISCOLL JR. , from the Wall Street Journal

The chorus for nationalizing America’s struggling banks is growing louder, and support for the idea comes from strange sources.

Alan Greenspan has said that he understands that “once in a hundred years” the government needs to take over the banks, and now is the time. Sen. Lindsey Graham, a Republican from South Carolina, has called for doing what works and “if nationalization is what works, then we should do it.” That is the kind of pragmatism that leads to socialism.

There is a great deal of imprecision in all the talk of nationalizing banks. The government, through the Federal Deposit Insurance Corp. (FDIC), temporarily takes over insolvent banks when it closes them. When it can, the FDIC sells a failed bank to another institution. Sometimes the purchaser does not want some or any of the failed bank’s assets. The FDIC must either then pay the buyer to take the assets (subsidize expected losses) or take over those assets. In a limited number of cases, there is no buyer for a failed bank. IndyMac Bank is a notable recent example. It has been operated since last year as an FDIC-owned institution (IndyMac Federal Bank) with the goal of finding a private buyer.

Certainly, in the latter case, a government agency has taken ownership of a bank. The federal government, under the auspices of the FDIC, can be said to routinely nationalize failed banks. There is nothing new about that policy and it certainly occurs more than once every 100 years.

There are some commentators, pursuing an ideological agenda, who want to use the current crisis to nationalize the entire financial system. That is nationalization in the style of a Latin American despot. It is presumably not what most advocates of bank nationalization have in mind, and certainly not what Mr. Greenspan or Mr. Graham are advocating. Those two advocate temporary nationalization of a limited number of institutions, until they can be restructured and put back into private hands.

The real issue is what to do with a subset of the largest financial institutions, the financial behemoths headquartered in New York City and other money centers, which are feared to be headed toward insolvency. (Some think they are already insolvent.) Treasury Secretary Timothy Geithner’s promise to “stress test” the major banks has fed the chorus of Cassandras. What if a major bank fails the test?

There are no good options and certainly nothing resembling a free-market solution. The government has put the taxpayer on the hook in a myriad of ways. First, there is deposit insurance. Second, there have been guarantees issued to certain creditors. Third, and most notoriously, the Treasury has invested taxpayer funds in preferred shares of certain institutions. Fourth, the Fed has lent funds on many of the dodgy assets of these banks. The Fed’s balance sheet should be consolidated with the Treasury’s in any cost-benefit calculation of alternative resolution strategies.

Ideally, the administration would adopt the least-cost method for the taxpayer of resolving the failure of a large bank. In principle, temporary nationalization in some instances could be the least-cost approach. The example of the Swedish banking crisis of the early 1990s is most often cited by nationalization advocates.

The conservative government of Prime Minister Carl Bildt took an aggressive approach to the banking crisis and is generally credited with having done a good job of resolving it. He acted quickly to guarantee all depositors and bank creditors. Asset values were aggressively written down. Public funds were used to recapitalize banks, for which the government received common shares to give any upside to the taxpayer. Two banks were nationalized entirely.

The rest of the story is an important element of Mr. Bildt’s success. His political opposition backed his government, at least in public. The bad assets, mostly real estate, were sold relatively quickly. The needed workouts brought cries that borrowers were being squeezed. In short, the resolution was handled professionally rather than politically.

The contrast with the current U.S. crisis could not be sharper. From the beginning, the handling of the U.S. crisis has been politicized. The partisanship is as toxic as the bad assets on bank balance sheets. Both parties are coming up with schemes to impede the process of foreclosing on homeowners who can’t afford their homes, which would get those homes into the hands of new owners who can afford them. Does anyone believe that a government bad bank will squeeze homeowners? To ask the question is to answer it.

Moreover, we know how the government runs financial institutions — consider Fannie Mae and Freddie Mac. Or IndyMac, whose management by the FDIC has been criticized for inflating the rescue costs through its liberal loan-modification program. A money-center bank in government hands would become a conduit for politicized lending and grants disguised as loans. That’s what’s happened at Fannie and Freddie. The government would never let go of its political ATM. You might as well consolidate such an institution with the Fed from the outset.

Mr. Geithner wants a public-private partnership to buy toxic assets from banks. All that government has done thus far has only scared private money off. As bankers now realize, when you turn to the government for financial assistance you take on an untrustworthy partner. Outside money will not come in only to see its investment diluted later on when the government injects additional funds.

Rather than focusing on ways in which we can further involve the government in the financial system, we need to find ways to extricate banks from government’s deadly embrace. Banks, at least the behemoths, were public-private partnerships before the crisis. Deposit insurance, access to the Fed’s lending, and the implicit (now explicit) government guarantee for banks “too big to fail” all constituted a system of financial corporatism. It must be ended not extended.

If a bank is too big to fail, then it is simply too big. Those institutions need to be downsized until their failure would no longer constitute a systemic risk. Then we can discuss how to untangle the government and the major banks, and create a banking system of genuinely private institutions.

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