DF's picture

    Fixing Finance

    So, I've gotten kind of impatient with waiting for Geithner or Bernanke or someone to explain exactly what they're going to do with the banking system.  I know that nationalization is way too scary to contemplate, despite the fact that the process the word actually refers to in this context has been ongoing with smaller banks and doesn't represent anything even remotely approaching permanent government ownership of these institutions, but what is the "public-private partnership" of which they speak?

    Well, I happened across this post on Greg Mankiw's blog.  It's from brack in the beginning of October, right when the market started to fall off a cliff, but I found this description to be informative:

    Whenever any financial institution attracts new private capital in an arms-length transaction, it can access an equal amount of public capital. The taxpayer would get the same terms as the private investor. The only difference is that government’s shares would be nonvoting until the government sold the shares at a later date.

    This plan would solve the three problems. The private sector rather than the government would weed out the zombie firms. The private sector rather than the government would set the price. And the private sector rather than the government would exercise corporate control.

    Why would an undercapitalized financial firm take advantage of this offer? Because it would need to raise only half as much capital from private sources, that financing should be easier to come by. With Warren Buffetts in scarce supply, the government can in effect replicate them, by pigging backing on what they do.

    Given, Mankiw was not describing whatever the current administration has in mind, but it sounds a lot like what a public-private partnership might look like.

    I have a couple of observations about all of this.  First, what Mankiw describes probably appeals to you if you think that private ownership of the banks must be maintained at all costs.  That appears to be the point of view of the current admin, as Geithner, Bernanke, Summers and Obama have all indicated that they want to avoid taking over the larger banks (and it's really primarily the big banks at issue here because, as I've said, we're already doing this with numerous smaller banks).

    However, this arrangement doesn't really clean up the mess.  If this prescription is really so much better than putting these banks in receivership, zeroing out shareholders and booting out current management, why isn't anyone making this argument clearly?

    One thing that really concerns me here is that I've heard it observed that one of the key steps in resolving financial messes of this stripe involves booting out the current management.  Sometimes this is referred to as "breaking the backs of the elites".  What you have right now, as Krugman continues to point out, is lemon socialism.  You have the same vanguard that failed to do their jobs being propped up by the taxpayer with no downside risk.  All they see right now is upside.  The public-private arrangement doesn't change this.  You'll have the same people running the show, except that it's arguably easier for them to attract new capital from the private sector, but only because the private sector knows that government will match what they put in.

    Other than that, you haven't gotten rid of the problem children and, with non-voting shares, the government doesn't really have any power to move things along any faster.  Given, almost half a year later, that the financial situation has gotten worse, not better, I wonder what Mr. Mankiw would say about it right now.

    All of this still leaves the question lingering in my mind: Why is the Obama administration working so hard to avoid biting the bullet on this?  I don't buy the explanation that it would be too complicated to put these larger banks into receivership.  On the one hand, it doesn't say much for the audacity of hope to simply say, "That's too hard!"  On the other hand, if these banks are "too big to fail" and to big to be dealt with like we deal with other banks in the same boat, then they need to be received and sold off.

    The last thing we want is zombie banks, managed by the same people who failed in their task and funded by the taxpayer, to continue their brain-munching feast on our economic outlook.



    Thank you for the post, DF.  I hope you can get some participation here because I think you asked the right question, Why won't O. admin dive in?  This is not like Obama to avoid the hard thing.  What has made this pragmatic president hesitate on this?  What information is available to him that we don't have?  Have the Goldman boys infected the whole administation?  I am begining to think those big bank are sitting on something so scary even Obama needs to hide it from the public.

    Here is a link to a possible reason.


    Foreign investment meets foreign policy?

    This makes sense. Nationalization may be the simplest, cleanest, most efficient and cheapest way to to go, but the foreign-policy cost may be unacceptable.

    Thanks for this link.  This is definitely a potential reason for avoiding nationalization and one that the admin wouldn't necessarily go on television to discuss.  It's also a fine example of how politics and economics overlap.

    Great post, DF. Three questions (at least) are suggested:

    1) Would it work in the short term? That is to say, would a government match offer catalyze investment?

    I don't buy it, no pun intended. I don't know the world that Mankiw describes, but it sounds much like the venture capital notion of a "lead investor." In private equity, the lead investor sets the price and negotiates the terms with the investment target. But most investors don't like to go it alone. They want to dilute the risk. I've known companies that get a lead investor but fail to get any other investors, so the lead backs out.

    Mankiw' suggestion seems to be that the government let private investors take the lead. In the example I just mentioned--where there's a lead but no followers--that would be great. But this scenario is uncommon. Usually, if you can get a lead investor, the followers aren't tough to find. So this solution could lubricate deals by guaranteeing that the government will follow, but the real problem is finding leads. So the plan would help somewhat, but I doubt that it would help enough to thaw the frozen markets. It's like defrosting a turkey with a hair dryer.

    2) Would it work in the long term? That is to say, would it reform company management?

    I disagree with you in that there's little reason to think that government officials would be much more stringent than private investors. First, private investors might be easygoing when the money is good, but in this economy, I don't see them being very permissive about poor management. Second, just because someone works for the government, doesn't mean that they'll crack the whip that private investors avoid. Third, at least private investors have a bottom line. No government official will be fired for letting a zombie bank zombie on.

    3) Why does Obama hesitate?

    Nationalization is fraught with with risk, from bureaucratic red tape, to mismanagement by unaccountable and virtually unfirable government employees, to straight up corruption and scandal. It may be that we have no other option, but IMO, nationalization is a last resort. It may be projection, but I see Obama as looking at it the same way.

    I pondered offering a similar critique of Mankiw's proposal.  I'm skeptical of whether this would get the credit markets moving again, but mostly because I don't see this as a means to clear the market.  The impasse right now is that major banks don't want to admit how bad their assets are, yet everyone knows that it's a bad situation.  So attracting new investment under these circumstances doesn't appear to be working.  Mankiw seems to argue on the basis of multplying the number of Warren Buffets out there, but there aren't a lot of half-Buffets either.

    There may appear to be little reason to think that government officials would be more stringent, except that in reality it gets done.  It's happened before and it's happening right now with smaller banks.  It may seem somehow counterintuitive that people with the skillset to clean up a bank and willingness to work in the public sector even exist, yet they do.  The exception here seems to be reserved for the big boy banks and there's got to be a reason for this.

    Did you see this?

    Under the deal, the Treasury Department agreed to convert up to $25 billion of its preferred stock investment in Citigroup into common stock, giving taxpayers more risk, but more potential for profit if the company recovers. The Treasury will convert its stake to the extent that Citigroup can persuade private investors, including several foreign government investment funds, to go along. Treasury will match the private investors’ conversions dollar-for-dollar, and do so at the most favorable price and terms offered to any other private investor.

    As for government officials being more stringent, I'm sure that it's happened before and could be happening now, but this is a statistics game for which there are no comparative statistics. There are examples of effective public management and ineffective private management. And there are examples of the converse. The examples of public mismanagement are egregious enough for me to be very cautious about employing it. Not that it isn't necessary, just that there are reasons to hesitate which aren't only political.

    Yep.  I saw this, too.

    I suppose what I find most odd is the seemingly ideological preference for a private solution to this problem.  Given where we are, this makes no sense to me.  When you add that there's a pretty considerable consensus among mainstream economists that nationalization is probably inevitable because the banks are actually insolvent.. well, let's just hope that the upcoming stress tests move things along.  Right now we don't have a functioning credit system, which we sorely need because the economy is contracting faster than was previously thought.

    Awesome. More great economic news.

    I think that the "ideological bias" against nationlization serves a valuable purpose. It helps the government to maintain a healthy separation from private enterprise, in contrast to Russia's gazprom or Japan's postal-service-cum-savings-bank. This mentality has helped us to enjoy the longest, largest period of growth of any nation in history.

    The downside is that this bias keeps us from nationalizing industries that would be better off nationalized, like health insurance, and discourages us from taking over troubled banks.

    I think that you're right that it needs to happen, that it will happen, and that we should do it sooner rather than later, but I do think that there is something inherently and importantly troubling about taking over banks. So even though it should happen, I don't find it odd that Obama is loathe to do it.

    It serves a valuable purpose as long as it's not an excuse for for avoiding pluralist solutions on a purely ideological basis.  It's not as if anyone is actually entertaining the idea of government running the banking system.  Hell, we don't even have a fully public central banking system.  Private hands abound.

    Health insurnance is a great example of how avoiding pluralist solutions on an ideological basis is screwing us over.  Quite possibly the best example.  I've got more on this that I'll be addressing soonly.

    As far as the process goes right now, I really just wish that I could know more about the conversations taking place at high levels.  I know this isn't a practical wish, but it would be nice to know that the level of awareness about these problems is higher than it looks on the face of it.  I'm sure it is, but it would be nice nonetheless.

    Latest Comments