It seems as though a day cannot go by without hearing the N-word. That's right, I'm talking about nationalization.
Even the thought of the word is enough to send some people into tirades against Big Brother, socialism and liberals. Upon reflection, the idea of nationalizing our banks may not be as terrible as it initially appears.
It is best to begin by exploring the problem itself before we begin to consider potential solutions. A significant fraction, if not most of major banks in the United States are now insolvent. Their liabilities are greater than their assets resulting in negative net worth – this usually precipitates bankruptcy proceedings. The insolvency in the financial sector has caused most credit channels to freeze up. The banks, worried about their own financial health, are refusing to lend money out of fear which could worsen their situation. The inability of credit-worthy individuals and firms to obtain credit has a further chilling effect on the economy that is worsening every day.
When a business is unable to get a loan, it often must scale back its operations. The firm reduces production and employees are laid off or their hours are cut. Those laid off no longer have a steady source of income and must cut back on their consumption. This weakening demand will then produce another round of businesses scaling back operations and a downward spiral ensues.
It is useful to see if history can teach us anything about the problems we face. As Mark Twain said, "History does not repeat itself, but it does rhyme." Similar crises have occurred before, notably in Sweden and Japan.
In Japan, an investment bubble grew due to easy credit. When it finally popped, investment levels crashed and the economy was sent plunging. The Japanese central bank lowered the interest rate to zero, but it failed to jump-start the economy. When banks became insolvent, the government offered them subsidies. The result was so-called "zombie banks" — banks neither fully alive nor dead that could not exist without government support. The recession that followed the bursting was not as catastrophic as it could have been, but it was prolonged. For 10 years Japan experienced no economic growth leading some to call this time period the "lost decade."
Sweden experienced a speculative housing bubble similar to what just occurred here in the United States. When the bubble deflated in 1992, credit channels froze up and the financial sector saw widespread bank insolvency. The Swedish government took decisive action that let everyone know it was engaged with the problem. The government guaranteed all bank deposits and debts and also assumed the bad debts of failing banks. The bad banks were forced to issue common stock to the government in exchange for debt assumption. The banks that were taken over by the government had their bad assets transferred to asset-holding companies, where they were eventually sold off. The proceeds from this went back to the state. When the banks were considered to be solvent, the ownership shares were sold on the market and the government was able to recoup much of its initial outlay.
The problem in the United States, as I see it, is fairly straightforward. Banks are unhealthy and have stopped lending, and this is sending ripple effects throughout the whole economy. So what options are available to us?
The first is simply to do nothing. Proponents of this option claim that we should allow the market to take its course, eliminate any government intervention or regulation of the financial markets and let the banks find their own route to solvency. This is an appealing argument but one that fails to appreciate the scope of the problem. If a single bank found itself in dire straits, it would be appropriate to allow the bank to declare bankruptcy. The insolvent bank would then be taken over by the Federal Deposit Insurance Corporation, shareholders would lose all their equity, creditors and depositors would be paid back and the bank would disappear. The problem is there are too many banks that are in awful shape. Aside from whatever impact this would have on the markets, it would also most likely make the FDIC insolvent. This is what happened to the Federal Savings and Loan Insurance Corporation during the savings and loan crisis in 1989. We further deregulated savings and loans when it was first realized they were in a dangerous condition. This was done so that the taxpayer would not have to bail them out. The result was that they dug themselves deeper into a hole and the resulting bailout was even more costly. The FSLIC ultimately went bankrupt and was phased out of existence. The magnitude of the problem we face precludes this option.
The second option is to inject money into the banks by purchasing the assets, which are polluting their balance sheets. By replacing the toxic assets with liquid capital, banks would be on sound financial footing and have all the necessary liquidity to start lending again. This option has its own pitfalls. The first is that nobody knows how to price these assets and how much the government would or should pay for them. If we are to use the market price as an indicator of value, then these assets are essentially valueless. Even if we fixed the banks' balance sheets through an injection of cash, there are no provisions to correct the behavior that got us here. Taxpayers should not pay to reward failure and incompetence. If they are paying, they should be getting something for their money.
This leads us to the third option: nationalization. What this would amount to is the government injecting capital into the banks and receiving ownership of the banks in exchange. Before you even begin to cry "socialism," you should realize that if any private investor gave money to a corporation, they would expect to receive equity in the business. Why should the government be expected to do something that no private individual would do? Through a stewardship model, the government can go through the balance sheets and determine how badly each bank is actually doing and how much capital would be necessary to fix it. When the banks have returned to a state of financial normalcy, the government would be able to recover some or all of its initial investment through dividends or selling the equity stake.
Critics of this option often bring up several points as to why this cannot work. First, it is claimed that government has no knowledge or expertise in dealing with insolvent banks. This is false — government actually has plenty of experience in these matters through the FDIC and formerly the FSLIC. Second, it is claimed that government intervention would be an affront to laissez-faire capitalism. The truth is that laissez-faire capitalism never existed and even if it did, so what? The government is doing what it is supposed to do — provide protection for its citizens. Rabid lust for deregulation is what created this crisis. Having the government take over failed banks for a period of time is far from the Soviet-style central planning which many libertarians seem to fear. Third, it is said that nationalization could never work in America — it is against our culture. This is essentially throwing a political bone into an economic argument — it is there to confuse and obfuscate. It should be noted that in the past it was not in our culture to allow women, minorities or anyone without property to vote. Time has passed and our culture has changed in response to dynamic conditions. There is no reason to think that our culture and mindset cannot change again. The fourth, and perhaps most plausible argument against nationalization, is that it cannot work because the scale of the task is too enormous. This argument claims that the Swedish model worked because there were fewer failed banks and Sweden is a smaller country than the United States. I see no reason as to why this means nationalization must fail. It simply means that we must be willing to embrace it on a different scale — larger problems require larger solutions.
None of these options are especially appealing. As it often is in life, we must settle for the lesser evil. The cost of inaction is too high. Pumping more money into the system without getting anything back simply delays the solution. The government has no alternative but to temporarily assume control of banks that would otherwise fail. To allow the financial system to collapse is simply not an option. The government must demand common stock in exchange for any capital injections. The existing management must be replaced as well. When the banks have been found clean by truly independent auditors, then the shares can be sold off. The banks will become re-privatized and we, the taxpayers, will get at least some of our money back.
Alexander Draine is a Rutgers College senior majoring in economics. His column, "Draine on Society," runs on alternate Tuesdays.