Free Market Bank Nationalization

I believe that bank nationalization is now very likely.  It may even be desirable.  The term nationalization, however, clouds judgment on both sides of the debate.  It's better to think of what we want to do as bankruptcy.  Many of the major banks are insolvent.  When the liabilities of an ordinary firm exceed its assets the firm enters one of a variety of types of bankruptcy procedure during which management is often removed, the firm is sold or reorganized and liability holders take ownership or are paid off at a discount.  Notice that we do not call a bankruptcy procedure, nationalization, even though it typically occurs under the auspices of a government employed judge. 

When it comes to the banks the issue is more complicated than with an ordinary firm because the major liability holders are depositors whom the government has guaranteed.  As a result, the ultimate liability holder is the government.  But now, as a thought experiment, imagine that we had private deposit insurance.  What would a private insurance firm do in this situation?  Would it pander to the current bank management and carry the zombie banks on its books, hoping and waiting for a miracle?  Or would it step in, remove current management, pay off the depositors, reorganize and then sell the banks to recoup its losses?  I believe a private insurer would follow the second path, the fact that the government is not yet ready to do this indicates how powerful bankers are in Washington.  Thus, given deposit insurance the procedure most consistent with free market principles is bankruptcy, preferably a speed bankruptcy procedure under the auspices of the FDIC which has significant expertise in this field.

A speed bankruptcy;  1) punishes current management reducing moral hazard, 2) will be less politicized if done under the auspices of the FDIC than if done piecemeal with congressional involvement and 3) will get the banks working again as soon as possible.

Notice how the term nationalization confuses the issue.  First, it suggests government ownership of the banks which would indeed be a disaster.  People in favor of free markets will rightly want to avoid any such outcome but ironically it's the current situation of "wait and see," and "protect the banker," which is likely to lead to an anemic recovery and eventual government ownership.  Second, it confuses people on the left who think that nationalization is a way to insure that taxpayers get something on the upside.  That idea is a joke – there is no upside.  Taxpayers are going to have to pay through the nose but the critical point is that the taxpayers must pay the depositors whom they have guaranteed not the banks.

The debate so far has been framed between a "bailout" and "nationalization." But the public rightly sees the bailout as a way to protect bankers and thus we get pressure for government ownership, which has already happened in part through government control over banker wages.  Bankruptcy in contrast is a normal free market procedure, it emphasizes that the firm has failed and current management should be removed.  Framing the issue in this way, for example, makes it clear that only the depositors should be protected and under reorganization there should be no control over wages on future management (wages are going to have to be high to get anyone to take on the task).  Finally the idea of bankruptcy makes it clear that the goal is to get banks solvent, under new management, and back under private control as quickly as possible.

Addendum: Garett Jones nicely lays out the case for doing the normal thing.


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