The Worst Option, Except for All the Others

by Ryan Avent

While the stimulus debate has sucked up most of the oxygen in the business press of late, some attention has been paid to one of the other many crises ongoing, namely, the sorry state of the banking sector. The Washington Post summed up the problem not long ago:

The basic problem confronting the government is that banks hold large quantities of assets that they value on their books for much more than investors are willing to pay. Banks cannot sell these assets without recording massive losses. But holding the assets is tying up vast amounts of money, choking the financial system.

The administration’s proposed solution, initially, was to divide assets into three categories (bad, kind of bad, and really bad) and ignore, insure, or buy those assets as necessary, spending a lot of money in the process — the scope for this kind of thing could easily get into the $2+ trillion range. That seemed to infuriate everyone, so the government has offered a new plan, in which it will do much the same thing, only less so. The plan, now, is to guarantee some assets and buy others at a price between book value (what the banks say an asset is worth) and actual value, using money from the second half of the TARP allotment, that is, something less than $350 billion. Which basically means that the adminstration seems content to perpetuate the old policy of doing something inadequate because something has to be done.

The issue is this — banks have assets that are worth much less than they’re currently being valued on the books. If banks fix this problem, they are suddenly and obviously insolvent. If they don’t, then they linger on in zombie mode, dragging down the broader economy, for years. The government therefore has to get rid of some of these assets. If it pays book value, then the taxpayers basically hand an extraordinary amount of money over to the banks. If it pays market value, the banks are insolvent. If the government pays something in the middle, then the taxpayers take a bath, and the banks are probably still insolvent.

A very bad solution to this crisis is nationalization. It’s bad because there are risks that the government will run the banks poorly, or make questionable loans, or that nationalization will be contagious — fear of nationalization will cause investors to abandon healthy banks, forcing the government to nationalize the entire banking sector instead of just the rotten firms. But as bad as nationalization is, it’s better than the other available solutions. No one wants to take this step, but given that taxpayers are going to be spending tons of money and taking on piles of risk to fix the banking sector, it makes sense that whatever value is left in the firms be confiscated to offset the costs (with the understanding that they’ll be re-privatized as soon as conditions allow).

Absent a definitive solution to this problem, banks will linger on in zombie mode, afraid or unable to facilitate economic activity appropriately. A definitive solution sans nationalization means an extremely expensive, and in all likelihood politically impossible, transfer of government money to the banks. It’s time to get over our fear of the word nationalization and do what’s best for the economy and for taxpayers.