Banks: Time for Permanent Nationalization?

By Fred Moseley, Dollars and Sense. Posted March 3, 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. 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.

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

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