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Fred Moseley

Time for Permanent Nationalization

by Fred Moseley

24 February 2009

The Treasury Department’s recent bailouts of major U.S. banks will result in a massive transfer of income from taxpayers to those banks’ bondholders.

Under the government’s current bailout plan, the total sum of money transferred from taxpayers to bondholders will probably be at least several hundred billion dollars and could be as much as $1 trillion, which is about $3,300 for each man, woman, and child in the United States. These bondholders took risks and made lots of money during the recent boom, but now taxpayers are being forced to bail them out and pay for their losses.

This trillion-dollar transfer of income from taxpayers to bondholders is an economic injustice that should be stopped immediately, and it can be stopped-if the government fully and permanently nationalizes the banks that are “too big to fail.”

The TARP program (“Troubled Assets Recovery Program”) has gone through several incarnations. It was originally intended to purchase high-risk mortgage-backed securities from banks. But this plan floundered because it is very difficult in the current circumstances to determine the value of these risky assets, and thus the price the government should pay for them. The main policy for the first $350 billion spent so far has been to invest government capital into banks by buying preferred stock (which is the equivalent of a loan), which receives a 5% rate of return (Warren Buffet gets a 10% rate of return when he buys preferred stocks these days) and has no voting rights. Managers of the banks are not being replaced, and there are usually cosmetic limits on executive pay, unlikely to be enforced. So these bank managers, who are largely responsible for the banking crisis, will continue to be rewarded with salaries of millions of dollars per year, paid for in part with taxpayer money. Existing bank stock loses value as the bank issues stock secured by TARP funds.

But the main beneficiaries of the government bailout money are the bondholders of the banks (see sidebar, “Bank Bonds,”). In the event of future losses, which are likely to be enormous, the government bailout money will be used directly or indirectly to pay off the bondholders. This could eventually take all of the available TARP money, and perhaps even more. So the government bailout of the banks is ultimately a bailout of the banks’ bondholders, paid for by taxpayers.

The Bush administration’s rationale for this approach to the bailout was that if the government did not bail out the banks and their bondholders, then the whole financial system in the United States would collapse. Nobody would lend money to anybody, and the economy would seize up (in the memorable words of George W. Bush: “this sucker would go down”). Bush Treasury secretary Paulson presented us with an unavoidable dilemma-either bail out the bondholders with taxpayers’ money or suffer a severe recession or depression.

If Paulson’s assertion were correct, it would be a stinging indictment of our current financial system. It would imply that the capitalist financial system, left on its own, is inherently unstable, and can only avoid sparking major economic crises by being bailed out by the government, at the taxpayers’ expense. There is a double indictment here: the capitalist financial system is inherently unstable and the necessary bailouts are economically unjust.

But there is a better alternative, a more equitable, “taxpayer friendly” option: Permanently nationalize banks that are “too big to fail” and run these banks according to public policy objectives (affordable housing, green energy, etc.), rather than with the objective of private profit maximization. The nationalization of banks, if it’s done right, would clearly be superior to current bailout policies because it would not involve a massive transfer of wealth from taxpayers to bondholders.

Besides providing a more equitable response to the current banking crisis, nationalizing the biggest banks will help ensure that a crisis like this never happens again, and we never again have to bail out the banks and their bondholders to “save the economy.” Once some banks have become “too big to fail” and everyone understands that the government will always bail out these large banks to avoid a systematic collapse, it follows that these banks should be nationalized. Otherwise, the implicit promise of a bailout gives megabanks a license to take lots of risks and make lots of money in good times, and then let the taxpayers pay for their losses in the bad times. Economists call this dilemma the “moral hazard” problem. In this case, we might instead call it the “economic injustice” problem.

he best way to avoid this legal robbery of taxpayers is to nationalize the banks. If taxpayers are going to pay for banks’ losses, then they should also receive their profits. The main justification for private profit is to encourage capitalists to invest and to invest wisely because they would suffer the losses if their investment fails. But if the losses fall not on capitalists, but instead on the taxpayers, then this justification for private profit disappears.

Freed from the need to maximize short-term profit, nationalized banks would also make the economy more stable in the future. They would take fewer risks during an expansion, to avoid debt-induced bubbles, which inevitably burst and cause so much hardship. For example, there would be fewer housing bubbles; instead, the deposits of these megabanks would be invested in decent affordable housing available to all. With housing more affordable, mortgages would be more affordable and less risky.

The newly nationalized banks could also increase their lending to credit-worthy businesses and households, and thereby help stabilize the economy and lessen the severity of the current recession. As things stand, banks do not want to increase their lending, since the crediworthiness of any borrower is difficult to determine, especially that of other banks that may also hold toxic assets. They have suffered enormous losses over the last year, and they fear that more enormous losses are still to come. Banks prefer instead to hoard capital as a cushion against these expected future losses.

What the government is doing now is giving money to banks in one way or another, and then begging them to please lend this money to businesses and households. Nationalization is clearly the better solution. Instead of giving money to the banks and begging them to lend, the government should nationalize the banks in trouble and lend directly to credit-worthy businesses and households.

How would the nationalization of banks work? I suggest the following general principles and guidelines:

* The federal government would become the owner of any “systemically significant” bank that asks for a government rescue or goes into bankruptcy proceedings. The value of existing stock would be wiped out, as it would be in a normal bankruptcy.

* The government would itself operate the banks. Top management would be replaced by government banking officials, and the managers would not receive “golden parachutes” of any kind.

* Most importantly, the banks’ long-term bonds would be converted into common stock in the banks. This would restore the banks to solvency, so they could start lending again. The private common stock would be subordinate to the government preferred stock in the capital structure, which would mean that any future losses would be taken out of the private stock before the government stock. Bondholders could also be given the option of converting their stocks back to bonds at a later date, with a significant write-down or discount, determined by bankruptcy judges.

These “bonds-to-stocks” swaps (often called “debt-to-equity” swaps), or partial write-downs if the bondholders so choose, are a crucial aspect of an equitable nationalization of banks. The bondholders lent their money and signed contracts that stipulated that if the banks went bankrupt, they might suffer losses. Now the banks are bankrupt and the bondholders should take the losses.

This process of accelerated bankruptcy and nationalization should be applied in the future to any banks that are in danger of bankruptcy and are deemed to be “systemically significant.” This would include the next crises at Citigroup and Bank of America. Other banks in danger of bankruptcy that are not “systemically significant” should be allowed to fail. There should be no more bailouts of the bondholders at the expense of taxpayers. In addition, the banks who received some of the first $350 billion should be subject to stricter conditions along the lines that Congress attached to the second $350 billion-that banks should be required to increase their lending to businesses and consumers, to fully account for how they have spent the government capital, and to follow strict limitations on executive compensation. The government should withdraw its capital from any banks that fail to meet these standards.

here is one other acceptable option: the government could create entirely new banks that would purchase good assets from banks and increase lending to credit-worth borrowers. These government banks are sometimes called “good banks,” in contrast to the “bad bank” proposals that have been floated recently, according to which the government would set up a bank to purchase bad (“toxic”) assets from banks. The term “good bank” is no doubt more politically acceptable than “government bank,” but the meaning is the same. The only difference between the “good bank” proposal and the nationalization proposal I’ve outlined here is that my proposal would start with existing banks and turn them into government banks.

In recent weeks, there has been more and more talk about and even acceptance of the “nationalization” of banks. The Washington Post recently ran an op-ed by NYU economists Nouriel Roubini and Matthew Richardson entitled “Nationalize the Banks! We Are All Swedes Now,” and New York Times business columnist Joe Nocera has written about how more and more economists and analysts are beginning to call for nationalization: “Nationalization. I just said it. The roof didn’t cave in.”

Even former Fed chair Alan Greenspan, whom many regard as one of the main architects of the current crisis, recently told the Financial Times that (temporary) nationalization may be the “least bad option”: He added, “I understand that once in a hundred years this is what you do.”

But there are three crucial differences between such pseudo-nationalizations and full-fledged, genuine nationalization:

* The pseudo-nationalizations are intended to be temporary. In this, they follow the model of the Swedish government, which temporarily nationalized some major banks in the early 1990s, and has subsequently almost entirely re-privatized them. Real nationalization would be permanent; if banks are “too big to fail”, then they have to be public, to avoid more crises and unjust bailouts in the future.

* In pseudo-nationalizations, the government has little or no decision-making power in running the banks. In real nationalization, the government would have complete control over the banks, and would run the banks according to public policy objectives democratically decided.

* In pseudo-nationalizations, bondholders don’t lose anything, and the loans owed by the banks to the bondholders are paid in full, in large part by taxpayers’ money. In real nationalization, the bondholders would suffer their own losses, just as they reaped the profits by themselves in the good times, and the taxpayers would not pay for the losses.

In mid-February, Treasury Secretary Timothy Geithner announced the Obama administration’s plans for the bank bailout-renamed the “Financial Stability Plan.” This plan is very similar to Paulson’s two versions of TARP: it includes both purchases of high-risk mortgage-backed securities from banks and also investing capital in banks. The main new feature is that government capital is supposed to be invested together with private capital. But in order to attract private capital, the government will have to provide sufficient guarantees, so most of the risks will still fall on taxpayers. So Geithner’s Financial Stability Plan has the same fundamental flaw as Paulson’s TARP: it bails out the banks and their bondholders at the expense of taxpayers.

The public should demand that the Obama administration should cancel these plans for further bank bailouts and consider other options, including genuine, permanent nationalization. Permanent nationalization with bonds-to-stocks swaps for bondholders is the most equitable solution to the current banking crisis, and would provide a better basis for a more stable and public-oriented banking system in the future.

Fred Moseley is a professor of economics at Mt. Holyoke College.

Published in Dollars & Sense Magazine.

SOURCES: Dean Baker, Time for Bank Rationalization,; Willem Buiter, Good Bank/New Bank vs. Bad Bank: a Rare Example of a No-Brainer,; Krishna Guha and Edward Luce, Greenspan Backs Bank Nationalization, Financial Times, February 18, 2008; Joe Nocera, A Stress Test for the Latest Bailout Plan, New York Times, February 13, 2009; James Petras, No Bailout for Wall Street Billionaires,; Matthew Richardson and Nouriel Roubini, Nationalize the Banks! We’re All Swedes Now, Washington Post, February 15, 2009; Joseph Stiglitz, Is the Entire Bailout Strategy Flawed? Let’s Rethink This Before It’s Too Late,

Bank bonds

Bank bonds are loans to banks by the bondholders, in contrast to common stocks, which are capital invested in banks by its owners. Bank bonds are a relatively new phenomenon in the U.S. economy (and the rest of the world). Until the 1980s, almost all loans by banks were financed from money deposited in the banks by depositors. Then in the 1980s, banks began to borrow more and more money by selling bonds to bondholders; this became a primary way that banks financed their loans. This debt strategy of banks enabled them to invest ever-larger sums and make more profits. However, this debt strategy left the banking system more unstable and vulnerable to collapse because banks would have to repay their bondholders. And when major banks were unable to do so, the banking system fell into crisis.

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