I was going through the comments in Bobswern’s post on the BofA developments and came across this comment from Lying Eyes:
The audience on this blog is very intelligent but there are numerous levels of knowledge on how the financial system works. Some don’t have a clue beyond their own finances and some have expertise. I think it’s practically impossible to have a good discussion on economics here because of that discrepancy. Hence, people shout a lot of nonsense.
I figure I have a reasonable knowledge base about the system – if I don’t, it means I have truly terrible powers of observation – and I am happy to shout nonsense. So I’d like to try to explain what I believe to be an important political point, and I am going to try to do it without jargon.
The difference between “nationalization” and “receivership”. Or, why many of the advocates for “nationalization” on this site are pushing the debate in the wrong direction.
Nationalization
There are plenty of advocates on Kos of nationalizing the banks. The word, however, is rarely defined. I’m going to change that. I will suggest that nationalization means a government takeover of a business with the intention of owning it.
The classic example of nationalizing the banks took place in France after the 1981 election of Mitterrand (curiously, the same year Reagan took office in the US). In 1982, the French government bought – on a compulsory sale – the banks and finance companies across France; by the time it was done it held 90% of the public’s deposits.
This – and the parallel takeover of the top dozen industrial conglomerates – didn’t make France some Maoist state. Folks still came and went as they pleased, had really good food and really bad cars, and did all the things that make French people French. It wasn’t the end of the world.
It was, however, a pretty lousy way to run the finance industry. It makes the banks subject to every manner of political pressure. It means capital is overallocated to heavy industry – always easy for a big company to lobby the government to give easy terms on debt – and it means capital is underallocated to the poor and newly arrived – the regulations aren’t designed for marginal people, so good luck with that mortgage, recent Algerian immigrant.
It would be even worse in the US. We may think of ourselves as a pure, non-corrupt country, but my experience is that we have about as high a level of governmental corruption as you will find in a rich nation. This isn’t northern Europe, or Canada, or Australia, or Singapore, where you can expect people to run the government’s money with the same profit-maximizing interest they would bring to their own family finances. As Simon Johnson put it beautifully:
Think about what would happen if the American political system gets the bit of directed credit between its teeth, with all the lobbying that entails. If you want to end up with the economy of Pakistan, the politics of Ukraine, and the inflation rate of Zimbabwe, bank nationalization is the way to go.
All of the comments that banks should be treated as utilities run into the same problem. Regulation is great, but the sort of regulation that governs our local power companies results in cushy returns for the owners and politically-directed service levels. It barely works in a business where the product is as publicly visible as a power line; it won’t work with finance.
Receivership
Every bankrupt company is taken over by the state in a very special fashion. The state doesn’t try to run the company. It changes the structure of the company: it adjusts the ownership base, it allows certain contracts to be broken, it directs the business to a new stakeholder arrangement. And this receivership is exactly what the financial system needs.
The easiest way to accomplish this, of course, would be just to let financial firms hit Chapter 11 the way we let everything else go under. The banks are hardly more worthy of forebearance than the auto companies or airlines or steel mills. The problem with Chapter 11, however, is that the value of the going concern in a bank deteriorates far more quickly than any other industry.
When a steel mill enters Chapter 11, not much happens, as long as it can get some modest transitional funding. It can slog along for a year or two while a judge figures out who should own what. A commercial bank, by contrast, has demand deposits. If the bank goes down, either its existing depositors get stuck (which we as a society do not want) or it would need to find a new population of depositors to volunteer to be stuck. Not likely. Similarly, back when we had independent investment banks, they went borrowed billions of dollars overnight. As soon as there is a threat to the firm, the money cannot be rolled over. The bank cannot last the week.
Receivership therefore has to entail separating the good and bad assets of the bank on some structural basis – they literally have to end up in different companies. Hank Paulson realized this; his solution was to buy the lousy ones and let the current stakeholders benefit from the cleaned-up balance sheet. The idea lives on as PPIP. The alternate idea, which I support, is to buy the good assets (by definition easier to value) and let the risk capital of the old firms take the risk on the junk. The Paulson Plan is good for the existing bank creditors and bad for the taxpayer, the Bulow Plan (the name for the alternative) is good for the taxpayer and bad for the existing bank creditors.
In either case, though, the outcome needs to be a quick period of transition to a fully private, dynamic banking sector. And that is quite different from a “nationalized” system of finance.
Pessimistic Note
Finance companies will be more highly regulated. They need to be; folks selling insurance well in excess of their ability to deliver is a disaster. But a careful observer will note that the financial crisis hit big commercial banks (Citigroup), insurance companies (AIG), and of course the GSEs (Fannie/Freddie). These were always regulated enterprises! Hedge funds have come and gone, but by contrast their blowups have barely registered.
The mainstream finance sector will continue to have its bubbles and its crashes, and when it crashes it will run out of money. It’s the nature of the beast. Breaking up the big banks may introduce some more firewalls, but it won’t do anything of substance because the retail banks all do the same thing: they make loans to purchase houses (mortgages) and to support personal consumption (credit cards). As long as we have the post-1970s land use planning/zoning restrictions in California and the northeast, there will be enormous land price volatility from the supply caps. Those restrictions aren’t going anywhere soon, since current residents don’t want 60-story buildings going up next door. And this land price volatility will jerk around the banks until housing downpayments are sufficiently large (30%, 40%, 50%) to contain the entire swing. I look forward to reading the posts when all the banks in a market require half down at closing.
Optimistic Note
Right now, a fear of “nationalization” on the right and confusion over “receivership” on the left has given the government cover to protect creditors by doing neither. We can get through this crisis as soon as the government drops its insistence that creditors to the finance companies be paid out in full. From Willem Buiter:
We will have wasted a lot of time – the good bank solution and the slaughter of the unsecured creditors should have been pursued actively as soon as it became clear that most of the US border-crossing banking system was insolvent, but for past, present and anticipated future tax payer support. If the Treasury can be pushed into a pro-active policy by declaring, just before the beginning of the weekend, that most of the banks undergoing the Stress Test have failed them and moving these wonky institutions straight into the FDIC’s special resolution regime where they can be restructured according to the good bank model, we could have well-capitalised banks capable of new lending and borrowing by the beginning of next week.
The Kos community has done an amazing job over the past week getting the administration to reverse its position on torture – and I say this as someone who is opposed to torture prosecutions. That energy applied to making sure the taxpayer gets a fair deal and Bernanke stops his dedicated effort to run the world’s dumbest hedge fund will get us out of this mess.
