The Market Case For Nationalizing The Banks

I was not at all happy to read this in today’s NYT:

“Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.”

This strikes me as a very bad idea. Paradoxically, this is because I believe in markets. I explain why below the fold.

I think that markets need regulation for various reasons. Markets need rules according to which to operate (if you don’t think so, consider the case of Russia.) We also need rules to cover cases in which we think market solutions would be unacceptable: I imagine that if enough kids die of tainted milk, a decent market will in fact produce some way in which consumers can buy milk that is not at risk of being tainted, but since that will happen only after a number of kids die, we should opt for food safety inspections instead. We can decide that markets are a bad method for allocating some things, e.g. children. And we need to solve various collective action problems and market failures. That said, however, I think that the market is a very good way of transmitting price signals, and that while government can and should regulate it in various ways, its advantages should not be set aside without some good reason.

In the case at hand: if the banks Geithner is proposing to bail out were left to the market, and if decent accounting standards were applied to them, a number of them would presumably fail. Like any bankruptcy, this would be bad for a number of people — shareholders, their managers, etc. — but that fact is not, I think, a reason to prop them up, any more than the fact that the bankruptcy of my neighborhood pharmacy would harm its employees would be a reason to prop it up if it fell on hard times. We can debate how onerous bankruptcy should be, whether it matters more to penalize people who enter it or to allow them the possibility of a fresh start, etc. But the fact that it sucks to go bankrupt is, in itself, a good thing, insofar as it motivates managers to try to avoid it, investors not to invest in firms that are at risk of bankruptcy, etc.

In the case of the large banks, I assume that we do not want them to go bankrupt not because it would hurt their shareholders, but because their bankruptcy would have broader systemic effects that we find unacceptable. That’s fine. But in figuring out what to do about that fact, we need to try to preserve the incentives that bankruptcy normally provides.

To my mind, this means that we should proceed as follows. First, figure out exactly what it is that makes letting these firms declare insolvency such a bad idea: what effects we are trying to avoid. Second, try to craft a policy that avoids this particular bad consequence, while leaving the other disincentives to go bankrupt (or to invest in firms that are at risk of bankruptcy) in place. Third, if we can’t do that, try hard to create incentives that mimic the operation of the normal market incentives that our actions are preventing. (E.g., if we prevent banks from declaring insolvency, we need to provide some other disincentive to becoming insolvent, in order to avoid moral hazard.)

This is the main reason why I tend to favor nationalizing those banks that are insolvent, clearing up their balance sheets, recapitalizing them as needed, and sending them back into the private markets as soon as is prudent. I am not, in general, in favor of the government controlling individual banks. But in this case, if we don’t want to let the large banks declare bankruptcy, we need to provide some serious disincentives to their managers, investors, and bondholders. (I exempt depositors since I think that they should be insured, given the systemic value of avoiding bank runs.)

Nationalization would accomplish that. It would wipe out the shareholders and holders of unsecured debt, which is what the market would have done if left to its own devices. It would allow us to replace the senior management at the banks, which would give them every incentive to avoid needing to be nationalized. We would need to own the banks in order to do what needs to be done, and to do it as quickly as possible. This would mimic the market by treating the government as an owner in those cases in which it is, in fact, putting up the money: anyone else who provided this sort of capital would get ownership, and making an exception for the government would make government money more attractive than private capital. This would, I think, be a bad thing.

Nationalization would, in short, accomplish what my market principles tell me we should do: specify exactly what the bad consequence is that we want to avoid, and craft a policy solution that avoids this particular bad thing while either leaving other market signals intact or (where this is impossible) mimicking them. It would also allow us to return to what I take to be the right state of affairs (in which banks are private, and privately funded, and the government regulates them) as quickly as possible. (If you don’t like excessive government involvement in banking, it’s not clear why you’d prefer a long, drawn-out period of heavy government involvement over a shorter period of outright nationalization.)

Why not do this? One reason, I think, is terminology. It’s easy to assume that nationalization is the least market-friendly solution to this problem: after all, people who like markets are on the right and the more they like markets, the farther to the right they are. And people who like nationalization are on the left, and the more they like nationalization, the farther to the left they are. (I leave aside for now questions about whether this characterization is accurate; what matters is that a number of people think this way.)

This seems to me to be one of the many cases in which arranging policies on a spectrum distorts thought. I am on the left, and I like markets just fine, in the many cases in which they work. But no solution to the problem of the banks counts as a free-market solution. Banks were heavily regulated from the outset, so the idea that the banking industry ever counted as a free market is (I think) silly. In our present situation, anyone who does not want the large banks to go the way of Lehman Brothers, and who hopes that the government does something to avoid this, has given up on a pure free-market solution.

Nationalization might be on the opposite end of some imaginary spectrum from market solutions. But I think it is also the policy that both minimizes the time during which the government will need to take extraordinary measures to prop the banks up, and also does the best job of mimicking the incentives that the market would normally provide.

You can see the issue in a nutshell in this passage from the NYT:

“And for all of its boldness, the plan largely repeats the Bush administration’s approach of deferring to many of the same companies and executives who had peddled risky loans and investments at the heart of the crisis and failed to foresee many of the problems plaguing the markets.”

Would any normal market participant do that? Would (say) Warren Buffet provide vast sums of money to any firm while deferring to the people who got that firm in trouble in the first place? Not if he expected to stay in business.

Will the market function well if firms know that if they can only manage to become too big to fail, they can expect this kind of deference? I don’t think so.

Lining policies up on a spectrum rarely helps anyone to think clearly. In this case, putting nationalization at one end and markets on the other distorts the issues beyond recognition. We need to think clearly, not apply labels. And people who favor markets need to ask themselves: granted that the policy that Geithner seems to be about to recommend is friendly to particular bankers and firms, in what conceivable sense is it friendly to markets?