Non-Sequitur Objections to Bank Nationalization



William Isaac has a Wall Street Journal op-ed claiming that his experience at the FDIC during the time when Continental Illinois was taken into receivership has given him important insights into why we shouldn’t use nationalization as a solution to the problems of today’s large banks. The op-ed doesn’t, however, really do that. Instead, it just repeats a couple of common instances of argumentative ping-pong. One sequence goes like this:

  1. Me: The FDIC nationalization process works well for dealing with small insolvent banks, so faced with a large insolvent bank we should do something similar.
  2. Isaac: But we’re talking about much bigger banks, it’s a different situation!

The other goes:

  1. Me: A nationalization process worked well for Sweden in the early 1990s, so faced with a similar banking crisis we should do something similar.
  2. Isaac: But we’re talking about a much bigger country, it’s a different situation!

In both cases, it’s true, the scale is different. But you have to consider why nationalization is the appropriate response in other situations. The issue is that there are only really two other alternatives. One is that you can let the bank go under, thus ensuring that everyone to whom the bank owes money loses out and setting off a panic that paralyzes your financial system. The other is that you can just give free money to the bank, thus rewarding the managers and equity holders whose poor business decisions created the situation. Neither of those is a very appealing option. Thus, nationalization. Nothing about the banks in question being big, or about the United States being a large country, change the fact that the other options are bad. Isaac offers this alternative prescription:

The Obama administration should declare that nationalization of any major bank is off the table; that the government stands behind our entire banking system; and that our banks will continue to receive a nonvoting form of equity capital, such as convertible preferred stock, from the government to the extent needed. Yesterday’s joint announcement to this effect by the Federal Reserve, FDIC, the Comptroller of the Currency, and the Treasury is a critical step toward healing our banking system and economy. Well done.

This is the “free money” option. And while it’s true that our only examples of successful nationalization schemes come from much smaller countries, we do have an example from the world’s second-largest economy of what happens when you try to go down this road. It’s Japan in the 1990s and it didn’t work. Now it’s true that the fact that the alternative to nationalization failed in a large economy doesn’t prove that nationalization will work. In theory, it could just be the case that we’re screwed and that there’s no way for a large economy that runs into this problem to rescue itself absent decades of suffering. But it’s also possible that what’s been made to work in small countries can be made to work in large ones. And as Kevin Drum says, it’s not as if the government would be restaffing Citi and Bank of America de novo. By and large, the very people working at those banks today would keep on working there. Some senior managers would get fired. But the big difference is simply that you would create a situation where a robust bailout of the institutions doesn’t end up rewarding the existing shareholders and senior managers. Then you could do the bailout and refloat the bank to private investors. It’s not about having the government “run” the bank, it’s about making sure that bailouts don’t reward the wrong people.