Thursday, 29 January 2009

Bank Nationalisation Is Charlatan Medicine

It is now demonstrated beautifully that giganormous system level risks originate from the financial sector, which then banks accumulate in a very non-transparent way. As a consequence, an unexpected - and sizable - shock hit the global economy. The panic button was promptly jumped on, and governments around the world started to shoot emergency cash injections towards any bank standing up. (Ok, not quite anyone: sorry Lehman...)

Shockingly, even some decent economists started to advocate for state ownership of banks, arguing that nationalisation of the banking sector was the way forward. Ha!

Thread 1: Systemic Risk

Con, against the nationalisation of banks. Banking is not a strategic industry where direct security risks would arise.

Pro. However, it can create systemic risk that could (and did) result in a major disruption of the entire economic system.

Con. The level of systemic risk is contained by the set of (effective) rules that the banking system operates in. In other words, it is the regulatory-supervisory framework that sets the level of systemic risk. You could have fully private owned, and fully state owned banking system, and any of the two blowing up, or remaining in control.

Observation. Look at the relatively large number of banks in the mature world, which are in some form of community control, state, municipal, co-operative. Their exposure to the current crisis varies along their countries regulatory regimes, rather than their ownership background.

Thread conclusion. The presence of systemic risk in the financial sector is no valid argument for nationalisation.

Thread 2: Societal Needs 

Pro. If the banks were in direct state control, they would allocate their lending to areas where the society would really need it.

Con. There is no natural monopoly in finance. Instead: it works best when driven by private profit motives, as proven by not only the historical efficiency of most of the banking functions (market failure tends to originate from some external distortion), but also the innovation track record.

Observation. “Development banks” have, in general, been a disaster. You could perhaps argue that they can supplement outright government subsidies, but any of their efforts to compete with the ‘real’ banks has been a remarkable failure due to the inherent inefficiency coming with bureaucracy-determined allocation of credit.

Thread conclusion.
There is no valid efficiency argument for the nationalisation of banks.

Thread 3: Asymmetric Information

Pro. There is a major asymmetric information problem. Although mature supervisory agencies have strong mandate, and could, in theory, monitor every aspect of a supervised bank’s operations, in practice such full transparency is not possible. State ownership could increase the transparency.

Con. It is true that there is an asymmetric information problem. But. Changing ownership will not, in itself, alter the setup. There is no reason why an effectively run state owned bank would have different incentives not to allow full supervisory transparency than a private owned bank. In fact, what is needed here is a better regulatory coverage, which, I would argue, will not be achieved before a truly global regime is not implemented.

Observation. The banks that have rogue traders do not know of them. Obviously. So that will not be affected by state ownership. Whereas, the risks that are know, like large NPL stock in subsidiaries seated in other countries, are best controlled by a regulatory regimes that monitors all possible areas where subsidiaries may be. That is global.

Thread conclusion. There is a strong asymmetric information argument, but that calls for better, and, in particular, wider regulatory regime than nationalisation.

Thread 4: Crisis Action

Pro. The governments around world reacted to the financial crisis by de facto nationalisation of a host of banks. This has not stopped the crisis from deepening. Other, previously shielded banks are coming under threat from the ripples of the previous ones going down. Nationalising now, not as a long term policy, but as a short term crisis measure would reduce the societal cost of clearing out. Then once a new regulatory regime is implemented, the entire banking system can start with a clean slate.

Con. It is true that once the crisis has started, and mass bail-out was the chosen (accidentally emerged) technique of dealing with it, seeing it through might make a lot of sense. However, the bail-outs so far, essentially imply a full guarantee of the entire banking system. The first bail-outs might have made sense, as a short term policy, an attempt to stop the crisis unfolding. The implied full guarantee of the entire banking system was a gamble on not having to back the whole economy. It is over now, and very clear that none of the world’s governments is strong enough to bail out their respective national economies. (Even less so, if you take into account that the global linkages would mean that any of these governments would effectively have to back more than its national economy. Unless of course there was a fully global harmonisation of policy, and an enforcement of it. We end up with the global government function again.)

Observation. The implied probability of government default is on the rise in a large number of mature economies. At the same time several sovereign bailouts are on the way. This cannot go ad infinitum.

Thread conclusion. The reaction to the financial crisis in the form of de facto nationalisation of banks made (at least some) sense at the early stage. However by now, it is blowing budget capabilities up. No government is strong enough, and a sovereign default would be carry much higher systemic risk.

Overall Conclusion

Nationalisation of either the banks, or any other sector in trouble is not the way forward. It is merely a pseudo action (apart from the populism) instead of the politically still difficult support for the inevitable rise of the global economic governance architecture.

At this stage of the crisis, bank nationalisation is the charlatan’s medicine. It’s the global regulation, stupid.

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