Wednesday, January 28, 2009

An alternative to nationalization

Ricardo Caballero has an alternative to nationalization which is for the government to act as an insurance against uncertainty:
... there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.

A little background:
There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely. (From Part I of the column)
(From Part 2)

... I argue that an efficient solution involves the government taking over the role of the insurance markets ravaged by Knightian uncertainty.

... Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).

A simple example can reinforce this point. Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays one dollar to agent A, and the opposite happens in state Y. Thus, only one dollar is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only one dollar is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than one dollar. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.

Of course real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.

I am uncertain whether the pricing of the insurance is possible given the uncertainty. I am still in favor of wholesale nationalization as a way to reduce uncertainty quickly. In Part I of his column he said:
Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.

Early on in the crisis, there was a nagging feeling that policy was behind the curve; then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem; and finally, the most devastating blow came during the failure to support Lehman. The latter unleashed a very different kind of recession, where uncertainty ravaged all forms of explicit and implicit financial insurance markets.

In short, I am uncertain that the reduction of uncertainty by insuring against uncertainty will not in turn result in even more uncertainty due to implementation issues.

The strongest argument against nationalization comes from this report in WAPO:
Another danger is that by taking over a substantial portion of a bank's stock and wiping out the investment of the firm's other shareholders, the government could also precipitate a sell-off across the banking system as investors flee, fearing they could be next.

Which is why nationalization must quick and broad leaving only the smallest retail banks that are very clearly not impacted by the crisis independent. Of course, post nationalization is whole other subject matter. The end of capitalism perhaps.

Currently, it is unlikely that the US will take the lead in nationalization of the sector. Perhaps France or UK will be the leaders here.

Update: Tyler Cowen points out that nationalization might not be cheaper than a bail-out. If the sector suffers a loss whether we bail it out or take it over we still suffer the loss.

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