US Banks were also insolvent in the 80-ies and 90-ies

Experts almost unanimously are pushing for a nationalisation of the banking sector, especially in the US. As this decision will determine to an important degree the next decade, it might be interesting to look at some counterarguments before deciding. The case for nationalisation can besummarised:

... the government needs to plunge in, weed out the weakest banks, pour capital into the surviving banks and sell off the bad assets.

It is the basic blueprint that has proved successful, they say, in resolving major financial crises in recent years.

Japanendured a lost decade of economic stagnation in the 1990s before it adopted such measures from 2001 to 2003.

TheSwedishgovernment took tough steps in 1992 andWashingtondid so in 1987 to 1989 to overcome thesavings and loancrisis.

“The historical record shows that you have to do it eventually,” said Adam S. Posen, a senior fellow at the Peterson Institute for International Economics. “Putting it off only brings more troubles and higher costs in the long run.”

Estimates about the potential lossesin the banking sector are further mushrooming, and Roubini and others have calculated that 3,6 Trln USD could be a more accurate estimate of bank losses under certain scenarios.

But the discussion is not only about these losses when a certain scenario unfolds, but also about whether you should mark your bank balance sheets at the worst possible moment, or give time to go through the valley and see some assets recover. It is all about procyclicallity, and breaking a vicious circle. Raghuram G. Rajan, a professor of finance and an economist at theUniversity of Chicagograduate business school, draws the distinction between “liquidation values” and those of calmer times, or “going concern values.” In a troubled time for banks, Mr.Rajansaid, analysts are constantly scrutinizing current and potential losses at the banks, but that is not the norm.

“If they had to sell these securities today, the losses would be far beyond their capital at this point,” he said. “But if the prices of these assets will recover over the next year or so, if they don’t have to sell at distress prices, the banks could have a new lease on life by giving them some time.”

That sort of breathing room is known as regulatory forbearance, essentially a bet by regulators that time will help heal banking troubles. It has worked before.

The point which is important to see is that there are other scenarios than nationalisation which have worked in the past to solve a banking crisis on a gigantic scale.

I

n the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks.The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

James Surowiecki, the author of the "wisdom of crowds" and columnist for the New Yorker writes:

We need to be careful about extrapolating from history, particularly when the historical record is short. That’s one reason why I’m not convinced that nationalizing most of our major banks is the best solution to our current financial problems.

The case of nationalisation if often supported by the Swedish exemple. But this was very different from the current situation:

* the economy was growing

* it was a local problem

Let’s be honest. When the historical record of successful nationalization in response to a banking crisis consists of one or two examples (Sweden and perhaps Japan), thenthe historical record doesn’t prove anything, because the sample size is way too small to draw any meaningful conclusions.The best we can say is that in one particular case, a particular strategy worked. That’s a piece of evidence in favor of nationalization, but there’s no reasonable way to say it proves, or even makes it likely, that nationalization is the right approach.

Surowiecki points to the Eighties and other banking crises, and the fact that the financial system recovered without nationalisation and with lower costs than in the latter strategy. Surowiecki argues that the Eighties in the US have shown that according to mainstream economic thinking...

...the fact that those banks were not nationalized or forced into receivership should have created “more troubles and higher costs” down the road, propelling the U.S. economy into a “Lost Decade” like the one Japan suffered through in the nineteen-nineties.But none of those things happened: those banks recovered on their own, and most became quite healthy, while the U.S. economy grew briskly for most of the nineteen-eighties. Now, today’s banking problems are obviously not the same as the early nineteen-eighties. But, in a way, that’s the point: different situations require different solutions, and there simply aren’t enough historical examples to make it obvious which solution is best.(Nor is economic theory of much use in this situation, since there’s no convincing theoretical model explaining why nationalization is preferable, either.)

The point therefore is that economists should be humble.There is not a textbook answer to the current banking crisis. There is not one sure strategy for solving such a huge crisis. There is certainly not a painless solution. But saying that nationalisation is the only possible solution is not correct.

Nationalization may be, after analyzing all the costs and benefits, the best strategy. But that’s not because history tells us that it is.

What I want to underline is that such important decisions should be very well analysed, takkng into account a dynamic scenario, not a static analysis. Also the selffeeding circle of mark to market and recapitalisations (with important dilutve effects for shareholders) and its economic effects should be considered. Nationalisation is therefore one of the options, and might still be the best after reflection. But history shows that other strategies have been pursued successfully.