Why Nationalization is Not a “Market Solution”

Once considered a radical solution, the idea of nationalizing the banks is gaining popularity in both New York and Washington. The unpopularity of the Public-Private Investment Program (PPIP) has led many to wonder if just taking the banks whole would be a better option. While PPIP is not perfect and puts billions of taxpayer dollars on the line, having the government try to manage an entire financial institution would be endlessly worse.

Nationalization shifted toward the forefront of policy cures for the ailing financial sector in February thanks, ironically, to support from supposedly free market enthusiasts. NYU business professor Nouriel Roubini’s suggested in a Forbes column that nationalization would be a market-solution:

“All the schemes that have so far been proposed to deal with the toxic assets of the banks may be a big fudge–one that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.
“So, paradoxically, nationalization may be a more market-friendly solution to a banking crisis. It creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and, most certainly, even the unsecured creditors, in case the bank insolvency hole is too large; it also provides a fair upside to the taxpayer.”

The thought was endorsed by former-libertarian Alan Greenspan and several Republican Senators soon after.

But this is all bunk. The reality is that this theory that nationalization could really clean up the banks completely ignores established public choice realities.

The key argument for temporarily nationalizing the banks is that it would take less tax dollars (in theory) to pay down the debt directly than continue injecting capital through bailouts as we have been doing for the past six months. Because it could be cheaper, nationalization is considered more market-friendly.

Noubini and others also add that nationalizing all of the banks at once, cleaning them of toxic debt, and then selling them back to the private sector as smaller entities will stabilize the system by making sure everyone is healthy and splitting up the behemoth institutions considered “too big to fail.”

As nice as this sound, the idea inherently assumes the government is capable of effectively and efficiently cleaning the system, and that Washington can remain an objective arbiter in the nationalization process. But the fact is that the financial crisis is already so political, that legislators would not be able to help injecting themselves and their ideas into the business of business.

One only has to look as far as AIG to see that nationalization is a bad idea. This insurance giant considered too big to fail was given an $80 billion lifeline in exchange for virtual government ownership back in September. The Treasury Department claimed that it would recoup the costs plus interest in two years. But six months later, with $100 billion more bailout dollars kicked in, complications with executive pay, and massive debts leaving AIG twisting in the wind, it is clear the government does not have the capacity to effectively nationalize and fix firms.

At present, exactly how bank nationalization would work remains vague. Some have suggested nationalization would be nothing more than FDIC receivership. Under current law, the FDIC can take over an insolvent bank, guide it through the bankruptcy process, and sell its assets back to the private sector. This is what the government did with Washington Mutual temporarily, before passing it off to Chase, and what they did with IndyMac in 2008, though they have yet to find a buyer for that defunct institution.

In this way the FDIC has played a helpful role in orderly dissolving insolvent firms. But a wholesale capture of the banking industry would send the FDIC where it has never gone before. Nationalization would have to be forced, Hugo Chavez-style, on all the major banks, even the healthier ones suspected of becoming insolvent in the future. (Taking only the really bad banks would create unfair competitive advantages in the market and wouldn’t break up all of the “too big to fail” institutions.)

Forcibly taking controlling ownership stakes in the banks would be unprecedented for the FDIC, second only to former Treasury Secretary Hank Paulson’s “strong encouragement” to the big banks to take TARP money back in October. The FDIC having control of the whole banking industry would surely bring in Congress and the White House, politicizing the whole process. It would also create a very negative paradigm for the future, with the role of government taking on a whole new perspective in the public eye.

With the legislative branch involved, it is unlikely the banks could escape back to the private sector without being significantly shackled by government regulation. For instance, Sen. Dick Durbin (D-IL) is pushing a bill through Congress that would give bankruptcy judges authority to restructure residential mortgages to keep firms from foreclosing on properties. The idea, also supported by President Obama, has been fought by the mortgage lending leaders for over a year—but with the major banks, who are also the top mortgage brokers, in government control, there would be no significant opposition to this policy proposal.

Already Wall Street has begun to pull away from government assistance given the many regulatory strings Congress has tried to attach. “It’s just impossible to run our business in this environment,” a Goldman Sachs senior executive told the New York Times in announcing they would be returning the TARP bailout money.

Ultimately, government operation of the banks would dictate lending practices on political concerns, and perhaps even use capital for self-destructive purposes to meet a bureaucratic end. CATO’s Gerald O’Driscoll commented in a Wall Street Journal op-ed that: “a money-center bank in government hands would become a conduit for politicized lending and grants disguised as loans.”

The unfortunate reality is that everything Washington does is based on power. Politicians do what will get them elected, and what will give them more authority in government. The appointments to direct the nationalization process would all be political, and their activity would be political.

The political reality is an inherent part of the system, and not necessarily a bad thing (because public servants should be acting in the best interest of their constituency), but its just plain bad for business. And government has already proved time and again that it does not manage businesses well: the US Postal Service, Amtrak, Fannie and Freddie, to name a few are all running deficits.

There are a few who fear once the government gets its hands on the banks they won’t ever let their prize go. It is unlikely that the government would keep the banks long-term because political pressure would mount. However, six months ago no one would have believed the nationalization would be so popular in the financial world, so anything is possible.

Probably with this concern in mind, the new nationalization supporters have stressed the term temporary and even suggested some kind of timetable. Many are pointing the “Swedish model” as the inspiration for this idea. In the early 1990s the Swedish government took the nation’s financial assets and put them in a collective “bad bank” to clean up the system. By 1997 they had sold back all of banking assets seized at an average of 50 cents on the dollar and the economy was recovered.

There is hope among many in America that we would follow this example, nationalize the banks, and transfer them back to the private sector slowly. This would stand in stark contrast with the Japanese example of the same time frame that perpetually bailed out its “zombie” banks only to suffer a decade of stagnation. But the fact is that America is not Sweden. Our system is more extensive, more complex, and significantly more political. There is no way that nationalization (or wholesale receivership) and the process of de-nationalization would not become a bureaucratic nightmare.

The professed free market support Noubini argues that “market economies sometimes have market failures, and when these occur, there’s a role for prudential—not excessive—regulation of the financial system.” But this still begs the question: is the government any more equipped with the knowledge for how to fix the system then actors in the market place?

Noubini believes naysayers (such as myself) are suffering from “excessive ideological belief that there are no market failures” due to our “ideological blinders.” But he misses the point. The fact is that government has played a principle role in mucking up our economy, and politicans have misaligned incentives to operate businesses successfully, so Washington seems is a strange cleaning service to call.

The government is not all knowing, it does not have any special powers—well, except making money appear and disappear out of thin air. Noubini, Greenspan, and others want the government that directed Fannie Mae and Freddie Mac to increase subprime lending to get more people into housing, supported Citigroup as a viable firm to take over Wachovia just a month before Citigroup’s stock plunged on solvency concerns to be the arbiter of recovery for the entire banking industry—somehow that just doesn’t seem smart.

The declining perception of nationalization as a dirty word is evidence of the fiscal policy paradigm shift taking place in America. It is a shift that is even splitting the classical liberal base. This trend must be reversed, the idea of nationalization not only rejected but put completely out of mind.

And then the government should leave the market alone. It has already spent or committed over $11 trillion in deposit insurance commitments, loan guarantees, bailout grants, and Fed lending. The government can stabilize the market by promising not to do anything more, and let investors become active in the system again.

Its not a mantra due to ideological blindness, its just reality: the nationalization would make use worse off than before.