Wednesday, February 11, 2009

Nationalization is impractical

Nationalisation has been my preferred solution to the current crisis. Likewise it is also the preferred solution by Roubini, Stiglitz, among others. Yet this is seen as politically impractical and infeasible. Mankiw makes a case for being impractical (although he makes the case for his fiscal stimulus package) by quoting Friedman:

The role of the economist in discussions of public policy seems to me to be to prescribe what should be done in light of what can be done, politics aside, and not to predict what is "politically feasible" and then to recommend it.

Obama has ruled out nationalization based on the following:
In describing his approach to the financial meltdown, Obama cited past crises in Japan and Sweden, but said neither offers much help in resolving the current credit crunch. He said Japan lost a decade by "trying to paper over the problems" of its banking system, while Sweden nationalized its banks.

"Here's the problem - Sweden had like five banks. We've got thousands of banks," Obama said. "You know, the scale of the U.S. economy and the capital markets are so vast and the, the problems in terms of managing and overseeing anything of that scale, I think, would...our assessment was that it wouldn't make sense."

"What we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets and, and ultimately that's going to be the key to getting credit flowing again," Obama added. The president's remarks came hours after Geithner oulined plans to stabilize the financial system by injecting capital into banks, helping to determine prices of toxic assets weighing on firms' balance sheets and stemming foreclosures. Wall Street, which was hoping for more details, registered disappointment with the administration's announcement, sending stock prices sharply lower.

Perhaps the silence that has greeted the latest Treasury plan by Geithner is indicative of where we'll be going along for the next 5-10 years - creeping nationalization as each bank fails and is taken over (inevitably) while the economy slides further and further down into recession. As Mark Thoma says [emphasis mine]:

To me, Geithner's attempt at reassurance, that they're not quite sure how the program will work, or if they will get it right, but be assured that they are determined to keep tinkering with the program until it does work, has just the opposite effect. It undermines confidence. Why not wait until they actually have a plan before going public? Why were they in such a rush to reveal that they aren't sure what to do, or if it will work?

While I agree that there are thousands of banks in the U.S. my sense is that the problem is only concentrated in perhaps 20-30 of the largest banks - mainly NY banks who are engaged heavily in derivatives and asset backed securities. Once we fix those, 90 percent of the other banks can become healthy again as the financial sector frictions eases.

From Mankiw:

"The word 'nationalization' scares the hell out of people," Rep. Maxine Waters, D-Calif., said on "This Week." To combat that, some clever advocates of nationalization have come up with alternative names, including "government receivership" and "pre-privatization." (Source.)

The search for alternative names can be amusing at first, but I think there is more here than mere semantics.Why are people scared about the idea of nationalization? One reason is that it is a sign of the depth of our problems. A second, more substantive reason is that it seems to point in a bad direction. I certainly do not want the government deciding who deserves credit and who does not, what kind of investments are worthy of financing and what kind are not. That is a big step toward crony capitalism, where the politically connected get the goodies, and economic stagnation awaits the rest of us.

If the government is to intervene in a big way to fix the banking system, "nationalization" is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure.

More from Roubini:
There are four basic approaches to cleaning up a banking system that is facing a systemic crisis: recapitalisation of the banks, together with a purchase of their toxic assets by a government “bad bank”; recapitalisation, together with government guarantees – after a first loss by the banks – of the toxic assets; private purchase of toxic assets with a government guarantee (the current US government plan); and outright nationalisation (call it or “government receivership” if you don’t like the dirty N-word) of insolvent banks and their resale to the private sector after being cleaned.

Of the four options, the first three have serious flaws. In the “bad bank” model, the government may overpay for the bad assets, whose true value is uncertain. Even in the guarantee model there can be such implicit government over-payment (or an over-guarantee that is not properly priced by the fees that the government receives).

In the “bad bank” model, the government has the additional problem of managing all the bad assets that it purchased – a task for which it lacks expertise. And the very cumbersome US Treasury proposal – which combines removing toxic assets from banks’ balance sheets while providing government guarantees – was so non-transparent and complicated that the markets dove as soon as it was announced.

Thus, paradoxically nationalisation may be a more market-friendly solution: it wipes out common and preferred shareholders of clearly insolvent institutions, and possibly unsecured creditors if the insolvency is too large, while providing a fair upside to the tax-payer. It can also resolve the problem of managing banks’ bad assets by reselling most of assets and deposits – with a government guarantee – to new private shareholders after a clean-up of the bad assets (as in the resolution of the Indy Mac bank failure).

Nationalisation also resolves the too-big-too-fail problem of banks that are systemically important, and that thus need to be rescued by the government at a high cost to taxpayers. Indeed, the problem has now grown larger, because the current approach has led weak banks to take over even weaker banks.

Merging zombie banks is like drunks trying to help each other stand up.

Again Roubini with Richardson:
Nationalization is the only option that would permit us to solve the problem of toxic assets in an orderly fashion and finally allow lending to resume. Of course, the economy would still stink, but the death spiral we are in would end.

Nationalization -- call it "receivership" if that sounds more palatable -- won't be easy, ...

Axel Leijonhufvud calls this a balance sheet recession, and adds:
But the American ideological taboo against “nationalisation” also stands in the way of dealing with the matter in the straightforward way that Sweden did. The present administration, like the last, would like to recapitalise the banks at least partly by attracting private capital. That can hardly be accomplished as long as the value of large chunks of the banks’ assets remains anybody’s guess. Government guarantees against (some part of) losses that may be incurred might solve this problem. But it would be a strangely contrived way out of a political impasse.

Fiscal stimulus will not have much effect as long as the financial system is deleveraging. Even if that problem were to be more or less solved, the government deficit would have to offset both the decline in industry investment and the rise in household saving – a gap that is rising as the recession deepens. Here, too, the public is sceptical and prone to conclude that a program that only slows or stops the decline but fails to “jump start” the economy must have been a waste of tax payers’ money. The most effective composition of such a program is also a problem.

Almost all American states now suffer under self-imposed constitutional balanced budget requirements and are consequently acting as powerful amplifiers of recession with respect to both income and employment. The states will spend everything they get, as will a great many local governments. The point of the stimulus package is to increase spending. Income maintenance for unemployed and other low income households will also be effective.

For a definition of balance sheet recession (from above Vox link):
Richard Koo (2003) coined the term “balance sheet recession” to characterise the endless travail of Japan following the collapse of its real estate and stock market bubbles in 1990. The Japanese government did not act to repair the balance sheets of the private sector following the crash. Instead, it chose a policy of keeping bank rate near zero so as to reduce deposit rates and let the banks earn their way back into solvency. At the same time it supported the real sector by repeated large doses of Keynesian deficit spending. It took a decade and a half for these policies to bring the Japanese economy back to reasonable health.

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