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Tilting at Windmills

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February 10, 2009
By: Hilzoy

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?

Hilzoy 12:05 PM Permalink | Trackbacks | Comments (30)

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Market didn't like Geithner's plan at all - everything plunged as soon as he started talking LOL

Posted by: Andy on February 10, 2009 at 11:41 AM | PERMALINK

Meet the new boss -- same as the old....

Ah, rich people giving our money to other rich people. It is hard not to be totally cynical, since it is clear that so much of this money is just being thrown away. Fuck.

Posted by: Obama -- Not as Tough as the Steelers on February 10, 2009 at 11:44 AM | PERMALINK

Maybe the administration will change their minds once they see how extraordinarily unpopular this will be? Even actual socialism is acceptable to most people if it is the alternative to rewarding banks and the executives who got us into this shithole.

Posted by: Shalimar on February 10, 2009 at 11:45 AM | PERMALINK

My first impression of Mr. Geithner was he seemed to me to be a duplicitous weasel. And unfortunately his actions are bearing out that impression. Bad Idea? It is not only a bad idea, but appears possibly a corrupt one as well. It's like locking a meth addict inside a laboratory with piles of Sudafed on hand. What could go wrong?

Posted by: Stuck on February 10, 2009 at 11:58 AM | PERMALINK

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.

How many retirees do you think this would leave destitute? And are they really the ones you want to punish?

Posted by: Danp on February 10, 2009 at 12:01 PM | PERMALINK

Could it be that Geithner believes the US can not afford to wipe out the current shareholders of troubled banks, since some of them are foreign investment funds from countries that he believes must not be alienated, so that they continue buying treasury bonds?

Or is he just ideologically blighted?

Posted by: SRW1 on February 10, 2009 at 12:08 PM | PERMALINK

Winston Churchill: "Americans always do the right thing, after having tried everything else first."

This is all kabuki theater to help out Geithner's buddies at the big banks. In the end it will cost tons of money, destory much of Obama's political capital and the government will still have to take the insolvent banks over, sort out the dead flesh from the live flesh, then re-privatize those banks.


Because that is the way the FDIC always handles troubled banks. They do this because it is the most efficient and economical way to fix a broken bank. They are actually quite good at doing this. The only thing novel here is the size of the banks. That's all.

These expensive work arounds won't work. Soon Giethner won't be able to find a job anywhere in the public or private sector, because he succumbed to a form of cronyism, was caught cheating on his taxe bill and will have lost total credibility.

Posted by: Tim Kane on February 10, 2009 at 12:09 PM | PERMALINK

Even the U.S. government doesn't have an inexhaustible supply of money. So far, nobody except Robert Reich has even tried to put a figure on the bad assets -- he believes it's north of five trillion and I believe that estimate is low. My fear is, after throwing trillions away trying to save the banks, the problem will still be there. The only sensible goal, it seems to me, is to protect as much money belonging to as many innocent parties (ie. depositors, bondholders and shareholders, in that order)as possible -- NOT the institutions themselves or some ridiculous ideological law that says nationalization is the end of the world. I think the markets are plunging because people realize Geithner is bailing the water out of the Titanic with a fork.

Posted by: dalloway on February 10, 2009 at 12:10 PM | PERMALINK

Danp: "How many retirees do you think this would leave destitute? And are they really the ones you want to punish?"

I'd be a lot happier wiping their bonds out and raising social security. I think people get higher yields from bonds because they are accepting risk and getting paid for it. I do not see why the taxpayers (many of whom are also retirees) should pay when those risks go bad. If the suffering is too great, we should ameliorate it directly, and for bondholders and non-bondholders alike.

Posted by: hilzoy on February 10, 2009 at 12:11 PM | PERMALINK

Fucking ridiculous and a really bad sign for the Obama administration. And, btw, we would have seen the same fucking thing from a Republican administration, and that's why I'm particularly pissed off.

Posted by: inthewoods on February 10, 2009 at 12:12 PM | PERMALINK

My first impression of Mr. Geithner was he seemed to me to be a duplicitous weasel. And unfortunately his actions are bearing out that impression.

Remember, he's Obama's duplicitous weasel.

Posted by: Econobuzz on February 10, 2009 at 12:19 PM | PERMALINK

This is particularly disappointing coming on the heels of Obama's masterful press conference and near-certain passage of the stimulus. They just threw a big wrench back in the works when they didn't have to--they obviously don't even have a complete plan. It's a mess and apparently no one likes it.

Posted by: Allan Snyder on February 10, 2009 at 12:20 PM | PERMALINK

Don't call it nationalization; call it creating a maxi-FDIC or something like that.

They may mean the same thing, but one term sets people's teeth on edge, and the other is fundamentally unobjectionable because the FDIC's been doing what it's doing for most of a century, and nobody's got a problem with it.

Posted by: low-tech cyclist on February 10, 2009 at 12:23 PM | PERMALINK

Important to remember that Geithner didn't just nominate himself, and he wasn't the one with the final say on the debate within the WH. Obama nominated him and stood by him and created the anticipation about this sorry excuse for a plan.

He should have let the debate continue and shouldn't have made an announcement without even being able to provide a cost estimate.

Posted by: Allan Snyder on February 10, 2009 at 12:24 PM | PERMALINK

Completely uninformed prediction:

After this "proposal" tanks in the markets, the congress, and in the court of public opinion, Obama may admit another screwup and come back with something better.

As with the kabuki outreach to Republican crazies (who then voted against the stimulus anyway), they had to graphically demonstrate why doing it the wrong way was bad, since otherwise the Village media would be second-guessing them forever ("if only they'd tried buying the bad assets instead of this horrible nationalization").

Posted by: jimBOB on February 10, 2009 at 12:28 PM | PERMALINK

Remember, he's Obama's duplicitous weasel.

I guess this means Obama isn't the messiah after all. My "TheOne" flag is now kerflunct. Drat!

Posted by: Stuck on February 10, 2009 at 12:32 PM | PERMALINK

Even actual socialism is acceptable to most people if it is the alternative to rewarding banks and the executives who got us into this shithole.

Seriously. Not to be a concern troll, but prior to this massive give-away to rich fucktards, I was a libertarian. Now that it's clear that we're never actually going to let things fail, it's hard not to want society to recoup its investment. If we're not going to let the financial system crater--and we shouldn't--nationalization seems to be the only equitable alternative.

Posted by: TW Andrews on February 10, 2009 at 12:34 PM | PERMALINK

I think people get higher yields from bonds because they are accepting risk and getting paid for it

Higher than what? CD's and money market accounts? The reason financial advisors advise retirees to buy bonds is that they are virtually no risk. Most of these bonds were rated AAA two years ago. And at 4-5% yield, we're not talking Granny at the slots. We are also not talking about the type of people who are sophisticated investors. I'd be far more sympathic to your argument if you were calling for bankers, ratings agencies, accounting firms and politicians to be charged with fraud.

Posted by: Danp on February 10, 2009 at 12:35 PM | PERMALINK

I guess, when Obama said, "What I won't do is return to the failed theories of the last eight years that got us into this fix in the first place, because those theories have been tested and they have failed", he meant those theories over there, not these failed theories here that keep the Big Money happy...

How anybody taking cues from Larry Summers can talk about turning away from the failures of the past with a straight face is beyond me. I guess that's what makes for an excellent politician. "I absolutely believe this bullshit I am telling you now. Yes I do. Really. Trust me."

Posted by: tatere on February 10, 2009 at 12:37 PM | PERMALINK

i have had to make it policy to keep forks and knives out of reach while reading about current events.

crap like this seriously makes me want to stab my eyes out with a fork.

Posted by: karen marie on February 10, 2009 at 12:47 PM | PERMALINK

A thinking person must wonder why did our president picked a Wall Street insider? Professor John Galbraith would have been a much better choice.

Posted by: capalistpig on February 10, 2009 at 12:52 PM | PERMALINK

What's astounding to me is how you Hilzoy can say in 16 paragraphs what could be covered completely in a quarter of that amount.

Posted by: Gandalf on February 10, 2009 at 12:54 PM | PERMALINK

I DON'T believe in "the market."

Adam Smith's invisible hand was based on his Enlightenment Deist belief in the "clockwork universe" wound up to run just as it is supposed to by the perfect, but thereafter hands-off, Deist Creator.

Well, contra both Adam Smith and the writers of the Constitution, things like the French Revolution, world wars, atomic weapons and the Holocaust have refuted such philosophical metaphysical idiocy.

Posted by: SocraticGadfly on February 10, 2009 at 2:20 PM | PERMALINK

My philosophy is WWWD: What Would Warren Do? As in Warren Buffet. If the American taxpayer doesn't get as good a deal as Warren then he is getting screwed.

Posted by: nat on February 10, 2009 at 2:23 PM | PERMALINK

Either through nationalization or as the end result of merger after merger after merger, coming soon: The Bank Bank!


Posted by: Zorro on February 10, 2009 at 2:29 PM | PERMALINK

After nationalization, we need to break them up so they are no longer too big to fail.

Posted by: Always Hopeful on February 10, 2009 at 2:36 PM | PERMALINK

Yes, nationalization would theoretically be the quickest solution. But how do we pay for it? All those words, and not one discussion of the cost. Did you see how hard it was to get $800 BB through the Senate? Now you want $5 trillion to nationalize the banks?

What is theoretically best is not always politically possible. It has nothing to do with vocabulary. The Republicans in the Senate are just not prepared to come along, yet.

Posted by: Patrick on February 10, 2009 at 3:28 PM | PERMALINK

That's what we need to do with our banks now--simply let them fail. The notion that a bank is too big to fail is false. Nations have failed, empires have failed, entire species have failed. And when these insolvent banks go down they take with them all the bloated CEO salaries, preferred and common stock equities, and hocus pocus 'assets' hidden in level three accounting tables, wiping the slate completely clean. The government protects only the FDIC insured deposits, which will be a Herculean task in and of itself. The Big Boyz who made all these bad bets just take their losses. Period. Then we start over, using any funds we can then manage to scrape together to ensure proper capitalization of the banks, all under new management, and with stringent new rules and regulations to prevent this from ever happening again. It means the end of an era of greed and corruption on Wall Street and in the board rooms of the banking system that boggles the mind every time I think on it, and good riddance.

Posted by: John Schettler on February 10, 2009 at 4:34 PM | PERMALINK

Everybody including the writer of this Washington Monthly should watch the enlightening video Money and Debt. It is idiotic that we are using tax payer money to bail out private banks so that they can fleece us. Obama should use Lincoln's solution, nationalize the banks that are too big to fail, cause the Secretary of Treasury to create our money and not the private banks. Among other good benefits, it would lessen the political power of Wall Street over our elected officials. Google for the video and also the American Monetary Act.

Posted by: Douglas R. Page on February 10, 2009 at 7:28 PM | PERMALINK
Adam Smith's invisible hand was based on his Enlightenment Deist belief in the "clockwork universe" wound up to run just as it is supposed to by the perfect, but thereafter hands-off, Deist Creator.

I don't think so. Smith's few comments about an "invisible hand" are a lot narrower in applicability than they appear out of context in the way they have been deliberately bent by later laissez-faire extremists.

One must remember that, while referring at one point in the Wealth of Nations to the aggregate of various individual actions aimed at serving individual interests aligning as if by an "invisible hand" to serve the common interest, Smith, at another point in the Wealth of Nations, note very much that the capitalist class (distinct, in Smith's time, from both the landholding class and the laboring class, though they have since essentially replaced landholding class as land became more easily tradeable as a commodity, due to reforms pushed, unsurprisingly, largely by the capitalist class) in pursuing its own interests does so in ways which must be vigorously defended against because they tend to oppose the common interest:

Merchants and master manufacturers are, in this order, the two classes of people who commonly employ the largest capitals, and who by their wealth draw to themselves the greatest share of the public consideration. As during their whole lives they are engaged in plans and projects, they have frequently more acuteness of understanding than the greater part of country gentlemen. As their thoughts, however, are commonly exercised rather about the interest of their own particular branch of business, than about that of the society, their judgment, even when given with the greatest candour (which it has not been upon every occasion) is much more to be depended upon with regard to the former of those two objects than with regard to the latter. Their superiority over the country gentleman is not so much in their knowledge of the public interest, as in their having a better knowledge of their own interest than he has of his. It is by this superior knowledge of their own interest that they have frequently imposed upon his generosity, and persuaded him to give up both his own interest and that of the public, from a very simple but honest conviction that their interest, and not his, was the interest of the public. The interest of the dealers, however, in any particular branch of trade or manufactures, is always in some respects different from, and even opposite to, that of the public. To widen the market and to narrow the competition, is always the interest of the dealers. To widen the market may frequently be agreeable enough to the interest of the public; but to narrow the competition must always be against it, and can serve only to enable the dealers, by raising their profits above what they naturally would be, to levy, for their own benefit, an absurd tax upon the rest of their fellow-citizens. The proposal of any new law or regulation of commerce which comes from this order ought always to be listened to with great precaution, and ought never to be adopted till after having been long and carefully examined, not only with the most scrupulous, but with the most suspicious attention. It comes from an order of men whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it.

(Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Book I, Chapter 11.)

If there is anything in Adam Smith's writing that ought to be burned into the mind of every citizen of a democratic state, it is that passage.

Posted by: cmdicely on February 10, 2009 at 7:41 PM | PERMALINK



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