by Peter Boone, Effective Intervention
and Simon Johnson, Peterson Institute for International Economics
Op-ed in the Financial Times
January 27, 2009
© Financial Times
If you hid the name of the country and just showed them the numbers, there is no doubt what old International Monetary Fund hands would say when confronted by the current situation of the United States: Nationalize the banking system. The government has already essentially guaranteed the system's liabilities, bank assets at market value must be massively lower than liabilities, and a severe global recession may yet turn into the Greatest Depression.
Nationalization would simplify the job of cleaning up bank balance sheets, without which no amount of recapitalization can make sense. An asset management company would be constructed for each nationalized bank, and loans and securities could be clearly divided into "definitely good" and "everything else."
Good loans would go into a recapitalized bank, where the taxpayer would not only hold all the risk (as now) but also get all the upside. Careful disposal of bad assets would yield lower losses than feared, although the final net addition to government debt would no doubt be in the standard range for banking fiascos: between 10 and 20 percent of gross domestic product.
As soon as you reveal that the country in question is the United States, the advice has to change. First, nationalization is an anathema in the United States. Second, the government has no record of running successful business enterprises. Third, think about what would happen if the American political system got the bit of state-directed credit between its teeth, with all the lobbying that would entail. 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.
Yet no one other than the government is available to recapitalize the banking system. Without sufficient capital, lending cannot be stabilized and any incipient recovery will be strangled at birth. The problem is the scale of the recapitalization needed to cover the real losses faced by banks. Additional capital is also needed to support the banks' (and everyone else's) desire for higher capitalization in the future. With the world economy still deteriorating, we need even more capital as a cushion against the worst-case recession scenario. These are just the direct recapitalization components. Asset management companies would have to pay cash for the distressed assets. Buying at current market prices should protect most of the taxpayer investment and is the only approach that will find political support.
The total of these figures suggests the government will need to come up with working capital in the region of $3–4 trillion. If things go well, the losses to the taxpayer should be quite limited, with the final cost closer to $1 trillion (€766 billion, £723 billion). But this requires that the taxpayer gets enough upside participation. How is this possible without receiving common equity that, at today's prices, would imply controlling stakes in the banks—that is, nationalization? We could receive a large amount of nonvoting stock, but a silent majority shareholder is an oxymoron who distorts the incentives of managers toward further bad behavior.
The most politically robust solution is for the government to acquire not voting stock but warrants—the option to buy such stock. These warrants would convert to common stock when sold, and a Resolution Trust Corporation-type structure could manage the disposal of these controlling stakes into the hands of private-equity investors. New owners would restructure bank operations, fire executives, and break up the banks (particularly if some antitrust provisions were added).
The sticking point will be banks refusing to sell assets at market value. The regulators need to apply without forbearance their existing rules and principles for the marking to market of all illiquid assets.
The law must be used against accountants and bank executives who deviate from the rules on capital requirements. This will concentrate the minds of our financial elite. Either they will raise capital privately or the government will provide, but this time on terms favorable to the taxpayer. The bankers' lobby, of course, will protest loudly. Good thing we now have a US president who can stand up to it.
Simon Johnson is a senior fellow at the Peterson Institute for International Economics and a professor at MIT.
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