The Baseline Scenario: March 9, 2009

Ethical Markets Reforming Global Finance

Nationalization for Beginners
Posted: 09 Mar 2009 10:13 AM PDT

“Nationalization” has been the word of the last month, with support not only from the usual suspects, but from Lindsey Graham, Alan Greenspan, and (to some degree, although they won’t say the word) Richard Shelby and John McCain. However, different people ascribe different meanings to this word; in particular, opponents like to define nationalization as the government taking over every bank permanently and turning banking into a government service.

As I see it, there are at least five different meanings of nationalization.

1. Owning more than 50% of the bank, by which people typically mean owning more than 50% of the common equity

This is a red herring, despite Treasury’s complicated efforts to keep its ownership stake in Citigroup below 50%. One entity can have effective control over another with less than 50% of its equity – through stock with special voting rights, or simply by being the largest shareholder. Conversely, one entity can own over 50% of another’s equity, yet not have any control, perhaps because it holds non-voting stock, or perhaps because it simply chooses not to exercise control.

2. Consolidating the bank onto the government balance sheet

Above 80% ownership, things do get serious: at that point, the bank becomes part of the government balance sheet (unless there is some special treatment for the U.S. government that I’m not aware of). This means, among other things, that the bank’s debt becomes U.S. government debt, which increases the potential liability of the taxpayer. This is why, for example, all of Iceland’s banks defaulted on their debt just before being taken over by the state; otherwise Iceland’s citizens would have become responsible for their debts. This is also why it is unlikely to happen here.

3. Turning the bank into a government agency

In this scenario, banking becomes a government service, like getting a driver’s license or going to the unemployment office. Banking decisions – how much to pay depositors, who gets credit, on what terms, etc. – become the province of government bureaucrats. This would most likely be a bad idea, because these decisions – which, collectively, shape the flow of capital through the economy – are best entrusted to the free market. This is why no one is seriously considering this option here. However, when people argue against nationalization, this is often the straw man they are aiming at.

4. FDIC-style conservatorship

This is what the FDIC does when a bank it insures fails. FDIC bank supervisors determine that the bank’s assets are worth less than its liabilities. The bank itself is shut down and its assets are transferred to a new entity controlled by the FDIC. The FDIC attempts to maximize the value of these assets, typically by selling them to another bank or banks. From the customers’ standpoint, little changes during this period: the branches, ATM machines, web site, and so on remain in operation during the transition, except that customer may not be able to withdraw amounts above the insurance limits. If the proceeds do not cover the bank’s liabilities, the creditors lose out, but the FDIC makes sure that all the insured deposits are paid back. Note that going into conservatorship does not mean that the bank is consolidated onto the government balance sheet; the liabilities are not automatically guaranteed.

#4 is what most proponents of nationalization mean.

Those are four different versions of what it might mean to nationalize a bank. In addition, there is another type of nationalization that must be discussed and that, in fact, has largely occurred:

5. System-level  nationalization

Banking in the United States, as in all advanced economies, has always been a public-private partnership rather than an unregulated free market. Banks play a critical role in the economy and therefore enjoy certain protections – such as FDIC insurance – and certain constraints – such as regulation. If the government had failed to act as the financial crisis unfolded, things would probably have gotten much worse, very quickly: not only Lehman Brothers but also Bear Stearns, Fannie Mae, Freddie Mac, AIG, Morgan Stanley, Citigroup, and probably Bank of America would have collapsed, causing trillions of dollars of losses for creditors and counterparties and bringing down other banks in sequence.

Instead, the government, primarily through the Federal Reserve, stepped into the breach. The government is the only source of capital for the banking system; it guarantees a large proportion of bank liabilities, including virtually all deposits and new bank debt; it implicitly guarantees all large banks under the Too Big To Fail doctrine; it ensures the liquidity that keeps the system afloat, both by providing cheap money and by lending against illiquid assets; and it has stepped up buying of various securities on secondary markets in order to encourage lending. In short, the government is where the money comes from, and the government decides on a high level where it goes, through capital injections, loans, and securities purchases. And the government bears the vast majority of the risk.

The net result is we have a semi-nationalized banking system largely made up of some very sick but private banks. As Thomas Hoenig put it:

We understandably would prefer not to “nationalize” these businesses, but in reacting as we are, we nevertheless are drifting into a situation where institutions are being nationalized piecemeal with no resolution of the crisis.

I am all in favor of debating to resolve the crisis. And I think that nationalization should be on the table, rather than being written off as some fundamental denial of the laws of physics.

President Obama’s Implied Future For Derivatives download madigan free godzilla divx

download Fiddler on the Roof
Posted: 09 Mar 2009 02:43 AM PDT

If you’ve worked on economic policy formulation – or in any large bureaucracy – you know how to get your boss to make the decision you want.  The key is to frame the options in such a way that he or she feels that your preferred course of action is the only plausible direction.  Alternatives need to be undermined or discredited.

Smart bosses know this, of course, and they seek out sources of information or analysis that are not managed by their subordinates.  The problem is that, traditionally, most such sources are not sufficiently well informed, at a detailed level, to be really helpful in the decision-making process.  The format of most mainstream media – 800 words for the general reader, 4 minute stories, etc – does not allow engagement at the technical level; and, to be honest, technocrats are very good at manipulating the information flow to even the best journalist (who is usually a generalist).  And while there are always outside technical domain experts, research papers appear with a lag and op eds usually have a broad brush (again, a format constraint).

Seen in this context, President Obama – on the face of it – has the role of blogs exactly backwards.  But perhaps he is instead telling us something more profound.

In Sunday’s NYT, the President is quoted as saying (at the end of the story),

Part of the reason we don’t spend a lot of time looking at blogs is because if you haven’t looked at it very carefully, then you may be under the impression that somehow there’s a clean answer one way or another – well, you just nationalize all the banks, or you just leave them alone and they’ll be fine.

Blogs relax previous format restrictions.  Length can vary, as can technical content.  Comments allow immediate feedback, clarification; debate is healthy for ideas.  Experts can now express a view or an endorsement immediately to a broader audience – and get pushback, as appropriate.

And, on the President’s point, experts can now talk directly to other experts at a very detailed operational level, and the results of that conversation are now public – and again attract public content (let’s be honest: sometimes experts are way off-base and they need to be told).  This is very threatening to official technocrats, both because their monopoly on expertise crumbles and because a broader set of people become skilled at criticizing their ideas.  These technocrats would much rather have their boss read newspapers and weekly magazines.

There is a good reason that the IMF is not free to speak candidly about the United States; it is full of experts who know what they are talking about.

But the President knows all this, which suggests another interpretation for his remarks.  Perhaps the financial situation – e.g., in and around derivatives – really is too complex for anyone to understand, unless they have the inside knowledge of regulators.  This would mean, of course, that going forward no one can question Treasury about anything important.

But that, in turn, makes congressional oversight impossible – even if we move to closed door hearings.  And it raises the question: if our financial system has become so economically complex that President Obama is right, then is it also too complex to be politically sustainable?

Big financial players now know they have a colossal potential put or bailout option.  They can also construct interconnected structures that no one can understand, except possibly the Treasury.  So every 10-20 years (or more often?) we will experience a crisis of current proportions?

There is a growing consensus that large banks should be broken up; no more “too big to fail”.  But the President’s implied point about economic/political complexity suggests that derivatives – for all their obvious potential benefits – are too dangerous to be allowed at anything like their current scale.  Who will be willing down the road to let Treasury, without outside comment or oversight, repeatedly provide massive amounts of resources to financial system insiders?

Derivatives have the potential to create a rent-seeking structure that is unparalleled in human history.  No society can afford to allow that kind of financial system to operate.  Either we figure out how to make it much more transparent – and amenable to outside review – or the re-regulation process currently in the hands of Senator Dodd and Congressman Frank needs to consider more radical alternatives.