As things stand, the banks are the permanent government of the country, whichever party is in power
Lord Skidelsky, economic historian and biographer of Keynes, in a speech to the House of lords
It’s time to put bank nationalisation back on the agenda. The recent revelations about the Libor scandal- revealing that fraud was routine, not just in Barclays, but across the financial services industry. I’ve outlined in an earlier post how I think this forms but of a wider practice of corruption. Clearly, there is something very wrong with the culture of banking.
A nationalised bank would not be a panacea to these problems, but by providing an alternative model, it would go some way to helping. Nationalisation would fix a number of other problems too: the moral hazard problem of banks being too big to fail could be solved, and a nationalised investment bank could provide a useful tool for ending the depression without increasing government deficits. It would also allow us to divert capital into much-needed projects: rebuilding infrastructure, creating green jobs, and providing loans to small businesses.
Of course, in the wake of the financial crisis, a huge number of banks have been nationalised. The UK government took a 100% stake in Northern Rock, 83% in RBS and 41% in Lloyds. The governments of the Netherlands, Luxembourg and Belgium forced Fortis into a “shotgun nationalisation“, whilst France, Belgium and Luxembourg also part-nationalised Dexia. Iceland’s largest banks, Landsbanki, Glitnir, Kaupthing Bank and Straumur Investment Bank were all nationalised. Spanish banks including Bankia have recently been partly nationalised. Even in the USA, where the politically charged term “nationalisation” has been avoided, de-facto nationalisation has been widespread: the Federal Reserve has effectively taken control of AIG, Fannie Mae and Freddie Mac, and the Treasury has taken a share in nine of the biggest financial institutions, including Goldman Sachs, Citigroup and Bank of America.
But the nature of these nationalisations has been short-term, and the business practices of the firms have been deliberately left unchanged (except in Iceland). The US government decided that not even a change of management was required, the leadership teams that bankrupted these institutions were left unchanged. The UK Labour and Coalition governments deliberately took a hands-off approach, doing little to increase lending to small businesses, reduce the bonuses or change the overall banking culture. The Coalition government has been so eager to sell the banks off, it has done so at a huge loss: the good parts of Northern Rock at a loss of £400 million, whilst the bad parts still owe the government £21 billion. In the partial sale of RBS, the government is expected to lose £2bn for every £1bn put in, amounting to perhaps £90bn in total. Instead of looking for new models of banking, Northern Rock has been sold to Virgin Money, whilst Abu Dhabi is buying parts of RBS.
Table of Contents
- Moral Hazard and the Maintenance of Market Discipline
- The Nordic Example
- The Debt Dilemma
- We Need National Investment Banks Now
Moral Hazard and the Maintenance of Market Discipline
We should be focusing on what works. We cannot keep pouring good money after bad. If nationalisation is what works, then we should do it.
Lindsey Graham, Republican senator from South Carolina
In his book The Return of Depression Economics and the Crisis of 2008, economist Paul Krugman describes moral hazard as “any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly”. Clearly, such a situation incentivises the risk-taker to take ever-larger risks: they stand to profit if the risk goes well, whilst the other party will pay if the risk fails. This is precisely the situation that occurs when businesses that are deemed “too large to fail” are propped up by the government: it leads to nationalised loss and privatised profits, incentivising business to take excessive risk, whilst the tax payer picks up the bill.
When a huge business fails, there are three possible approaches. First, there is the unbridled free market approach, of letting the business fail. This is often the best approach, but not always possible: the entire economic system depends on a handful of large and powerful banks. If they collapsed in 2007/2008, the entire world economy was at risk of imploding; we were staring into the abyss- some form of bailout was necessary. Good and bad businesses across the globe would have failed together, and ordinary people would have suffered beyond imagination. An alternative approach is for government to rescue the businesses, pouring in good money after bad. The third is nationalisation: the government rescues the businesses, but takes them over. The shareholders lose their invested capital, the managers who bankrupted the company lose their jobs.
In the current economic crisis, we have largely followed the second approach. As I mentioned earlier, even when banks have been nationalised, in most cases no serious efforts have been made to change the managerial structures of the companies. And often the banks have not been nationalised, money has simply been put in to propping up failing institutions. For example, in the US, the TARP (Troubled Asset Relief Program) alone involved a bailout of $431bn. The Temporary Liquidity Guarantee Program allows US banks to issue bonds backed by the government, essentially risk-free. The banks have accessed this market 97 times for $190 billion. The UK’s 2008 and 2009 bank rescue packages, together worth around £550bn benefitted a host of banks that experienced no nationalisation. The EU recently bailed out Spanish banks to the tune of €100bn. These programmes amounts to a huge, incentive-distorting subsidy of private business: something both the left and free-market right should oppose.
A classic case that should serve as a warning is Japan’s “lost decade” of the 1990s and 2000s. The government delayed any nationalisation program for years, prolonging the crisis. Banks were not forced to recognise the dire condition of their balance sheets- instead the government fed them money to invest in unprofitable, bankrupt firms. Often these firms were so deeply in debt, the money they received was simply used to pay off existing debts, rather than restructuring the company and returning towards profitability. By the early 2000s, 30% of businesses, controlling 15% of assets, had become so-called “zombie firms”, heavily in debt and contributing nothing to the real economy. Businesses were not allowed to fail, but were kept on life support from the central government, so the economy could not recover.
Eventually, Japan was forced into a temporary nationalisation of Japan Post and more drastic action to end the stagnation. By delaying in nationalisation for so long, the depression was greatly prolonged, and vast sums of money drowned in the unprofitable zombie economy. Japan perhaps the most extreme example of a moral hazard problem helping to weigh down an economy.
In the early 1980s, the US had faced a similar crisis to Japan: the Savings and Loans crisis. The US government at that point responded far more swiftly, and effectively (though not officially) nationalised failing institutions. As Paul Krugman writes, discussing the contemporary financial crisis:
A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders
By nationalising those institutions that are bailed out, the moral hazard problem can be solved. It allows us to protect the economy when huge institutions collapse, whilst avoiding distorting incentives, as would occur in simple bailout. Market discipline is preserved on the whole financial sector: shareholders will lose when the bank is nationalised, they have a huge incentive not to take undue risks. This means that large, solvent banks are forced to change their behaviour as well, in order to avoid nationalisation. The entire economy should benefit, and it is not unlikely that taxpayers could benefit from the program, once nationalised banks are once again in profit.
The Nordic Example
In the early 1990s, Sweden, Norway and Finland experienced a financial crisis, strikingly similar to the contemporary global one. Financial deregulation in the 1980s fed a frenzy of real estate lending by the banks, and a growing property bubble. In 1991 and 1992, the bubble burst, and banks were left insolvent. In Sweden, the structure of the financial sector was remarkably similar to the US today, with 500 firms, but just 6 controlling 90% of the assets.
All three countries eventually followed a similar route to solving the crisis. The banks were not simply bailed out, with the government taking over the bad debts. Instead, Banks had to write down losses and issue warrants to the government. The Swedish government passed legislation to allow the government to take control of banks where the capital adequacy ratio had fallen below 2%. “Bad banks” were establishedto hold the toxic assets, so they could eventually be sold once market conditions improved. Shareholders were left with absolutely nothing, but savers had their deposits guaranteed. Taxpayer money was used in the short-term, to give enough capital to allow banks to resume normal lending, but this money would eventually be recouped.
In Sweden, only two banks were nationalised. The other banks asking for a bailout were able to finance it themselves, and returned to solvency. The nationalised banks were merged into Nordea, now a highly profitable giant in the Baltic and Scandinavian region, in which the government still has a 19.9% stake. Finland also nationalised two banks, and Norway went further, nationalising all three of its largest banks, and retaining a 34% stake in the largest, Den norske.
The costs of the banking crisis were huge, although somewhat smaller than today’s crisis. Sweden spent 3.6% of its GDP in nationalising its failed banks, Finland 9.0%, and Norway 2.0%.
However, the solutions to the Nordic banking crisis are widely regarded as among the most successful in history. Soon after the plan was announced, the governments government found that international confidence returned more quickly than expected, easing pressure on its currency and bringing money back into the country. Moreover, the Norwegian taxpayer has been a net beneficiary of the crisis, profiting from the sale of the banks at an increased share price. Even the costs of the Swedish and Finnish bailouts turned out to be far less than expected, with costs close to zero for the Swedish taxpayer.
These policies stand in contrast to the British government’s decision to sell of its nationalised banks at huge losses to the taxpayer. But the Nordic governments could perhaps have even gone further still- by retaining control of these banks, and keeping them as profitable firms for the taxpayer.
Keeping a state investment bank provides an excellent way for governments to stimulate the economy, without increasing the government’s debt.
The Debt Dilemma
There is a clear contradiction in the current austerity policies being pursued by governments in Europe and America at the moment. On the one hand, they are determined to cut government deficits (and eventually debt), whilst also professing a desire to stimulate economic growth. Yet it is (private sector) debt that helped to cause the crisis in the first place, and in response to a dangerous economic climate, businesses and individuals always hold back, and save instead of spending and investing (this is what allows recessions to develop in the first place). It is a logical impossibility for government, businesses and individuals to be in surplus at the same time, so the government is left with the problem of promoting growth, in whilst every sector of the economy is choosing to cut back.
The most obvious solution, of course, would be for the government to slow down its rate of cuts and to stimulate the economy, as I have argued elsewhere. Clearly, the governments is unwilling to do this. There are, however, other ways to stimulate the economy. A National Investment Bank, owned by the state, could offer one obvious tool with which to use, if governments are willing.
Adam Posen, a member of the Bank of England’s Monetary Policy Committee, has called for a public bank to lend to small enterprises. The economic historian Lord Skidelsky has also argued that a publicly owned investment bank could provide the economic stimulus we need:
First, through its funding programme, it would create a new class of bonds – long-term, but with a yield pick-up over gilts, reflecting the modest credit risk of the bank – which could include features that fit the needs of the UK pensions industry, the need for renewing infrastructure and the demands for energy efficiency. Second, by lending for the long term, it would help long-term growth. And finally, by ramping up its operations now – when the corporate recovery is being hamstrung by shrinking bank lending and fiscal austerity – it can offer a boost to aggregate demand when it is needed most.
A National Investment Bank could borrow money cheaply (especially in the current climate of low interest rates) and use this to fund investments in the real economy. Whilst such an initiative would increase short term debt- by borrowing money, it would help to cut the overall deficit burden, by providing sources of income for the government. In effect, this would be a reverse of a Private Finance Initiative: instead of using expensive private capital to fund investments and build assets which are then leased to the public sector, the National Investment Bank could borrow money cheaply to finance growth enhancing investments and lease or sell them back to the private sector, providing income back to government. By lending to small businesses, we could boost demand. By investing in assets that come with a revenue scheme, the taxpayer would ultimately profit from such investments, and the economy would be provided with the stimulus needed to help escape this depression. High-return investments include roads (in the UK, the M6 toll road is running at a loss, but would turn a profit if funded at current gilt interest rates), railways, airports, extensions of high-speed broadband, and power stations- the economy is desperately in need of precisely these assets!
Recent economic stimulus has largely taken the form of quantitative easing: effectively printing money and handing it to the banks to lend. However, so far, the money has not been lent to other businesses: the market climate is still deemed to risky. Instead, the main beneficiary has been the financial services sector. A national investment bank would give the government a mechanism for injecting this capital directly into the real economy. Money could be directed into the most useful parts of the economy, and in particular green industries and jobs: the so-called “Green Quantitative Easing” approach.
(Although the British government has set up a so-called Green Investment Bank, its funding is a tiny £2bn, and it will not be allowed to borrow or lend money, as such it cannot really be called a bank at all.)
The European Investment Bank provides one useful example; in effect, it is a public investment bank. European governments have contributed about $50bn towards it, and it borrows a further $420bn, to finance investments worth $470bn. It has financed the port of Barcelona, the Warsaw beltway, France’s TGV network and Britain’s offshore wind farms. All these projects have had a large return on investment, benefiting hugely the European economy. Over five decades of existence, it has consistency turned a profit, the taxpayers have not had to fund it.
Surely the case for implementing such projects on a national scale is now overwhelming. A public investment bank could offer precisely the stimulus needed for the economy, without increasing government deficit.
We Need National Investment Banks Now
Of course, a nationalised bank is not a panacea to all ills in the current financial services sector. France’s state-owned Credit Lyonnais has a bad record: it wasted $5bn on Hollywood ventures and needed to be bailed out by its taxpayer owners. Saxony’s public bank, Sachsen LB, was one of the first German banks to disclose big losses on credit derivatives. However, overall, nationalised banks have been a (relative) success, at least in developed countries, where state-corruption is comparatively low. The world’s 5 safest banks are all state-owned, or quasi-stated owned, and in particular Germany’s diverse financial services sector has contained many successful state-owned or federally administered banks.
A nationalised investment bank would clearly be a good thing for the economy. Those banks which have been nationalised could easily be transformed into one, by any government courageous enough to do so. By creating such a bank, we avoid the issues of moral hazard when protecting our economy, and give an incentive for those banks still in surplus not to take unnecessary risks. We could use such a bank to make a profit for the taxpayer, instead of increasing the deficit. Such a bank could be used to stimulate demand in the economy, providing loans to small businesses, and investing in grand infrastructure projects that would permanently benefit the public. The case seems overwhelming.