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.
Policy Brief 13-21: Lehman Died, Bagehot Lives: Why Did the Fed and Treasury Let a Major Wall Street Bank Fail? September 2013
Op-ed: Misconceptions About Fed's Bond Buying September 2, 2013
Op-ed: A Dose of Reality for the Dismal Science April 19, 2013
Op-ed: Five Myths about the Euro Crisis September 7, 2012
Working Paper 12-7: Lessons from Reforms in Central and Eastern Europe in the Wake of the Global Financial Crisis April 2012
Article: Why the Euro Will Survive: Completing the Continent's Half-Built House August 22, 2012
Policy Brief 12-18: The Coming Resolution of the European Crisis: An Update June 2012
Policy Brief 12-20: Why a Breakup of the Euro Area Must Be Avoided: Lessons from Previous Breakups August 2012
Book: Sustaining China's Economic Growth after the Global Financial Crisis January 2012
Testimony: A New Regime for Regulating Large, Complex Financial Institutions December 7, 2011
Working Paper 11-2: Too Big to Fail: The Transatlantic Debate January 2011
Policy Brief 10-24: The Central Banker's Case for Doing More October 2010
Policy Brief 10-3: Confronting Asset Bubbles, Too Big to Fail, and Beggar-thy-Neighbor Exchange Rate Policies February 2010
Article: The Dollar and the Deficits: How Washington Can Prevent the Next Crisis November 2009
Speech: Rescuing and Rebuilding the US Economy: A Progress Report July 17, 2009
Testimony: Needed: A Global Response to the Global Economic and Financial Crisis March 12, 2009
Testimony: A Proven Framework to End the US Banking Crisis Including Some Temporary Nationalizations February 26, 2009
Speech: Financial Regulation in the Wake of the Crisis June 8, 2009
Paper: World Recession and Recovery: A V or an L? April 7, 2009
Op-ed: Stopping a Global Meltdown November 12, 2008
Book: Banking on Basel: The Future of International Financial Regulation September 2008