Why we were right not to nationalize the banks

By Felix Salmon
October 5, 2009
admitted I was wrong about bank nationalization, I've received a lot of pushback along those lines. Charles's comment is representative:

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Normally, when I admit that I was wrong, I don’t get a lot of responses basically saying “no, you were right the first time round”. But this time, when I admitted I was wrong about bank nationalization, I’ve received a lot of pushback along those lines. Charles’s comment is representative:

Really ? How did you come to that conclusion? As far as I can see, the “saved” banks are retreating on lending to SME and retail, stuffing their balance sheet with safe bonds (mainly govies) and recapitalizing themselves by taking advantage of the steepness of the yield curve. This has enormous opportunity costs for the taxpayer (these long bonds coupons will have to be paid one day…), depresses the “Real” economy, and is as close to “free lunch” for the banks than anything. The government, and the taxpayers, bear the burden of banking sector losses and get nothing in return. A nationalization has the same risks, but enjoys the potential upside.

One key point of my post was that the Obama administration is very good at tempering its initiatives with a clear-eyed view of what is possible and what isn’t. In the case of the decision not to nationalize the banks (which, it’s worth emphasizing, is different from a decision never to nationalize the banks), I think we’re seeing a real appreciation of the breadth of the possible unintended consequences, as well as the practical impossibilities involved in the government trying to run such an enormous banking book with so many different and competing parts.

How much of the decline in bank lending to individuals and small businesses is due to a drop-off in demand, and how much is due to banks’ increasing risk-aversion? It’s hard to say, but the former is clearly important, and having government-owned banks wouldn’t change that. Such lending is normally much more profitable than the big wholesale loans which banks have increasingly been keen on extending of late; that says to me that they’d be perfectly willing to make smaller loans if only there were reasonably high-quality demand out there. I might be wrong, but even if I am, it’s hard to see how government ownership would change things: government simply doesn’t have the ability to micromanage bank lending at that level.

The reason why I wanted to nationalize the banks is that they were suffering from a major liquidity crisis, and they were insolvent on a mark-to-market basis. In that situation, the government essentially has two options, when the banks are too big to fail. It needs to provide liquidity either way; the only question is whether it does so while taking ownership, or whether it leaves the banks to continue in their existing form, in the hope that the markets will recover and they will no longer be mark-to-market insolvent.

The latter is much easier, and is pretty much what happened. It also has the added advantage that you don’t have government ownership driving out private-sector risk capital. As an anonymous Treasury official says in Lizza’s piece, “People had money to put into banks. The nationalization crowd would have had the government putting all that money in.”

It’s true that when the government determines that a certain bank is too big to fail, and then lowers interest rates to the point at which the yield curve becomes steep, the result is a recapitalization of that bank through easy profits. And yes, those profits go to the bank’s private shareholders. You can call that a free lunch. The alternative, for taxpayers, is the possibility of a very expensive lunch indeed. Here’s Lizza again:

Furthermore, Summers said, there was a medium-term risk that nationalized banks would lose value, in the same way that the act of foreclosure decreases the value of a home. Summers pointed to the example of Sweden, which was regularly cited by economists who favored nationalization. But Summers noted that Sweden didn’t nationalize for two and a half years, by which time the situation had become so severe—interest rates had reached a hundred per cent—that there were no other options. In addition, Nordbanken, the largest bank nationalized in Sweden, was already eighty per cent government-owned. Summers concluded by emphasizing that nationalization was a strategy that governments turn to only after it is very clear that nothing else can work.

One of the problems facing Summers and Geithner when they made this decision was how to get the wholesale market in bank debt moving again. (Remember the TED spread?) Given that they couldn’t nationalize thousands of banks at once, and given that nationalization was tantamount to an admission that the banking system was insolvent, non-nationalized banks would have found it pretty much impossible to find funding at any level, and there might well have been a much larger number of bank failures than we’ve seen to date.

The fact is that nationalization is a negative-sum game. Just because banks are making large profits now, doesn’t mean that they would have made just as much under government ownership. And the political noise surrounding just about any decision that any nationalized bank made, especially as regards pay and bonuses, would have made any other kind of reform (healthcare, financial-regulation, you name it) even more difficult than such things have turned out to be sans bank nationalization.

Now that the results of the stress tests have been made public and the debt market has recovered impressively, there’s a strong case to be made that the banking system is no longer insolvent. If we could get here without the incredibly drastic measure of nationalization, that’s a good thing. Yes, we might have lost a bit of potential upside on our hypothetical equity stake in the big banks. And yes, it’s very depressing to see a large chunk of that upside going to the very bankers who helped drive the economy into the current recession in the first place. But let’s not kid ourselves that the nationalization option would have been trivially superior in all respects.

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