by hilzoy
Like Eric, 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?
"Too big to fail" is too big. Nationalization gives us a good way of breaking up the far- too- large banks into more manageable hunks.
Now, how to keep them from rebuilding (see the phone companies) or all making the same bad assumptions at once (current mess) is an Unsolved Problem.
Posted by: lightning | February 10, 2009 at 12:18 PM
Well said hilzoy. Part of your unending mission to make me feel inadequate through comparison ;)
Posted by: Eric Martin | February 10, 2009 at 12:22 PM
Eric: I thought it was the other way around -- there's a reason I don't write as much as I used to about Iraq, and it isn't lack of interest. ;)
Posted by: hilzoy | February 10, 2009 at 12:31 PM
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.
But is it easy to tell which banks are insolvent? Citi and AIG are toast, but BoA claims to not need more bailout cash. Is that true? What about all the banks that received TARP money but not "extraordinary assistance"? Nationalizing all of them would require an enormous surge of government resources and expertise - but letting them go on without aid would doom a lot of them to become insolvent where a not-huge injection of capital might keep them alive. It seems to me that nationalization is a very blunt instrument that faces a lot of allocation uncertainty issues - just like TARP I and II.
Posted by: MikeF | February 10, 2009 at 12:36 PM
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 is utter crap.
White House comment line: 202-456-1111.
h/t atrios.
By all means, call them up. Who knows, maybe it will make a difference.
Posted by: russell | February 10, 2009 at 12:38 PM
Pace Yves and others, I knew I was going to hate this plan once it came out. Looks like I'm not going to be surprised here.
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.
Best not to be coy here. The bad thing we have to avoid is a general systemic failure via cascading defaults of all the major participants in the banking system, in which swaps contracts (e.g. Credit Default Swaps) would play a large role, because the players are very tightly coupled to each other. That was what scared everybody so badly when Lehman failed - it became appalling obvious that the counterparties are so tightly tied to one another that you can't kill off one of them without killing them all.
The main advantage of putting the banks through what is effectively a bankruptcy and liquidation process (without actually calling it that) under the guise of nationalization is to avoid triggering a swaps cascade by pretending that the firm in question has not actually failed. The problem I see with this is I don't think you can actually get much in the way of liquidation (or "restructuring") done while still maintaining plausible deniability regarding the failure of the firm in question. At some point not very far down that road we will be forced to either freeze the zombie banks as they are, or to face the swaps contract monster.
I wonder if it would be simpler to declare the CDS en-toto as null and void, on the grounds of that they were effectively insurance contracts which were not submitted via the appropriate regulatory framework.
Would that be enough to decouple the fate of individual firms so the bad ones can then be allowed to fail without taking their counterparties down with them, and if this is desireable from a policy standpoint, can a legal framework be constructed to nullify the CDS market on a non-arbitrary basis?
I don't know the answers to those questions, but I think any solution to this problem which makes no attempt to untie the web of counterparty relationships binding all of the major banks to each other is doomed to end up at the same zombie-bank 1990s Japan style destination.
Posted by: ThatLeftTurnInABQ | February 10, 2009 at 12:40 PM
The main advantage of putting the banks through what is effectively a bankruptcy and liquidation process (without actually calling it that) under the guise of nationalization is to avoid triggering a swaps cascade by pretending that the firm in question has not actually failed.
Wouldn't it just be cheaper to keep the population stoned for the next 5 years?
Posted by: TJ | February 10, 2009 at 12:56 PM
TJ: Sign me up.
Posted by: Eric Martin | February 10, 2009 at 01:09 PM
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.
Agreed. This is more or less what I've meant in past comments when stating that I consider government to be a "necessary evil", and that it should be "as large as necessary and no larger."
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.
Well, I hate those stereotypes. People around here assume that I'm a Norquistian Republican because most of the time when I comment it's to ridicule your economically illterate, zero-accountability, big-government fetishist colleague, Publius; personally, I'd consider myself a socially liberal small-government libertarian. Nevertheless, I think your reasoning in this post is excellent, and I think you've laid out a good argument for nationalization.
I'm a big fan of competitive markets, because robust competition enforces accountability and spurs innovation, while monopolies, public or private, inevitably degrade. But perpetual competition is an unnatural state -- in nature, winners dominate and crush their rivals. It is sometimes necessary for a reluctant government referee to intervene to maintain a functioning marketplace. This is one of those times.
Posted by: Creamy Goodness | February 10, 2009 at 01:31 PM
illterate
Heh.
Posted by: Creamy Goodness | February 10, 2009 at 01:39 PM
Publius and Hilzoy are acutally different people with different ideas. Which makes your strident attack look a little silly...
Posted by: Sebastian | February 10, 2009 at 01:40 PM
Czarism in Action ...Sirota
"...the Treasury Secretary is circumventing..." ???
I always understood that the responsibility the last administrations crimes was assigned to Rumsfeld and Cheey so that when a Democratic neoliberal ascended to the throne those same voices could claim that the Czar(!) couldn't possibly know or understand what the Cossacks were doing.
Posted by: bob mcmanus | February 10, 2009 at 01:56 PM
I think Creamy means Hilzoy's colleague, whose name is "Publius." I don't believe Creamy was directly addressing Publius.
Posted by: hairshirthedonist | February 10, 2009 at 01:57 PM
Ahh, I see, I got distracted by the linky underscorededness. :)
Posted by: Sebastian | February 10, 2009 at 02:47 PM
The idea that the banks are free market adherents defies belief. We have a Crony Welfare State. They were betting on and expecting government guarantees purchased through lobbying. Geithner is talking gibberish. The plan perpetuates our Crony Welfare State arrangement. Are we spending any less than Britain or Sweden did? Please.
Posted by: Don the libertarian Democrat | February 10, 2009 at 03:07 PM
In case you haven't seen this yet (IIRC Yves may have a link up) it is worth a read: Ray Dalio thinks we need to nationalize the banks, but that is only a start. A broad restructuring (i.e. selective defaults and writedowns) of debt is needed. Some of this interview is just standard talking-his-book, but the key bits (IMHO) are this:
Posted by: ThatLeftTurnInABQ | February 10, 2009 at 03:13 PM
Hilzoy, well put, a very good summation of the problem with our reverse-Stalinist free-market ideology.
Your analogy here is instructive:
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.
Don't be too sure. Exactly that problem arose in the 19th Century, and the 'market' solution was to bypass the market and give the problem to the entity much better able to handle it, government. Our growing cities needed and got a better food distribution system, which was ripe for abuse by farmers and middlemen. Claims of adulterated milk were common enough to prompt Thoreau's famous quip, "Some circumstantial evidence is very strong, as when you find a trout in the milk." Once pasteurization and refrigeration were invented, doctors strongly recommended milk for children -- yet consumers could not count on the milk getting to their doorstep without being diluted and tainted. This children's health issue was one of the big spurs for the creation of the FDA and other regulatory bodies.
Could a market solution have been found? There were early private quality assurance bodies (Good Housekeeping, heksherers, etc.). But they could not as reliably monitor compliance or prevent abuse of their mark. Consumers could not count on private rating entities to do their job well or honestly -- a problem that played a significant role in our current financial crisis as well.
Of course, a government regulator can be incompetent, misled, or bribed as well. Some argue now that government pasteurization mandates destroy nutrients and make milk less healthy -- but having this argument in public is a big step up from trying to choose among competing private rating agencies.
Posted by: The Crafty Trilobite | February 10, 2009 at 03:32 PM
What will happen to the pile of bad stuff?
What are the possible things that *could* happen to the pile of bad stuff?
In other words, what options are there?
Posted by: russell | February 10, 2009 at 03:46 PM
A certain hysterically anti-socialist perspective was opposed to the U.S. government acting like a competent and interested customer / investor in negotiating for pharmaceutical prices for Medicare.
A related anti-socialist perspective now holds that the government should in no way act like a competent and interested customer / investor in bailing out failed banks with crashed assets and huge debts based on imaginary financial instruments.
There is a pattern here.
Posted by: El Cid | February 10, 2009 at 03:48 PM
Seems pretty sensible, but then, I am pretty hungover this morning. One comment got me, " It would allow us to replace the senior management at the banks, which would give them every incentive to avoid needing to be nationalized." Where do we go for the replacement senior management, particularly with salary caps in place (sure, I'll take a 2mm a year pay cut to try to fix a completely broken bank, no problem)? Will this turn out to be kind of like disbanding the Iraqi army? And finally, I am not getting the connection between firing senior management and incentivizing [who?] to want to avoid nationalization. Of course, maybe if I'd been a better person last night, this would all make sense. Can't rule that out.
Posted by: mckinneytexas | February 11, 2009 at 10:10 AM
Ironically, I think it's the bailout strategy, rather than a nationalization alternative, which so far has proved just how badly government can manage its money economically. After all, the U.S. government has now invested into Citigroup and Bank of America, for example, several times those firms' value on the stock market. And for its investment, it has received no control over those corporations.
If that's not bad business sense, I don't know what is!
Posted by: Dave | February 21, 2009 at 01:25 PM