The Volokh Conspiracy - Bailout, nationalization, policy, law.

Why do many economists prefer nationalization (or some more modest version where government takes control of financial institutions) to the bailout approach? Under the bailout approach, Treasury purchases mortgage-related securities from banks in a reverse auction. Currently, these securities are not being traded even though they clearly are worth something (they give holders the right to a fraction of mortgage payments, which is worth some amount greater than zero unless homeowners will default immediately and their houses are worth nothing in foreclosure). It is a bit of a mystery why no one will buy or sell them; apparently, they are too hard to value and holders don't want to dispose of them for minimal amounts because their price might rebound. So the toxic waste remains on their balance sheets, making it hard for outsiders to evaluate the solvency of financial institutions and thus reluctant to advance funds to them.

There seem to be two distinct objections to the bailout plan:

1. It's inefficient. If Treasury buys up an entire class of securities, it will buy them from solvent institutions as well as insolvent institutions. These solvent institutions don't need help from the government; only the insolvent institutions do. It would make more sense for the government to lend money to the insolvent institutions, or allow them to fail and take on (some of) their liabilities, while leaving the solvent institutions alone. To be sure, if the government pays the "right" amount for the mortgages, it doesn't subsidize the solvent institutions; but then it will also not help the insolvent institutions which will remain insolvent.

2. It's unfair. If Treasury wants to help insolvent institutions, it will have to overpay for the securities. But the government gets nothing in return for this money, which will end up in the pockets of shareholders to the extent that it exceeds what is necessary to return these firms to solvency. Meanwhile, the solvent institutions that sell their securities at a high price get money for nothing, which ends up in the pockets of rich shareholders (of course, not all of them are rich).

Under the nationalization approach, the government gives money to institutions in return for equity, which makes the government a part- or full-owner of the institution. The government doesn't buy up healthy institutions, just insolvent or near-insolvent institutions. If these institutions recover, the government makes a profit; if not, at least their shareholders get nothing. Meanwhile, as institutions become healthier, they will become more willing to trade their mortgage-related securities (why, exactly?) or at least they can hold them until maturity without failing. The nationalization approach is more efficient than the bailout because it focuses government resources on the institutions that need help. And it is fairer because taxpayers don't subsidize healthy institutions and they obtain a return if failing institutions recover.

I have two questions about this argument. I haven't found answers on the web or in the academic literature, and would grateful be if commenters would answer them or point me to relevant discussions.

1. In both cases, the degree of unfairness and inefficiency is a function of the competence of the government regulatory authorities, not the design of the law itself. If the government pays the correct prices under the bailout, it won't end up subsidizing the healthy institutions; if the securities are worth more in the government's hands, then taxpayers will make a profit when they mature. To be sure, the correct pricing won't help rescue insolvent institutions; it will just make them easier to value; but the government retains the option to lend to these institutions, buy them, or help them in other ways, under its existing legal authority. So the bailout has to be accompanied by equity infusions, but no one has claimed that it wouldn't be. If we can't trust regulators to price securities correctly, that bodes ill for nationalization as well. The government has to price the equity correctly. The government has to supervise the firm competently. And it has to sell the firm eventually. If the government can't determine the correct prices for purchasing mortgage-related securities, why do we think it can determine the correct prices when it sells off businesses? If it charges too little, it will end up transferring taxpayers' money to a class of rich investors. Bottom line: do the critics of the bailout make assumptions about the competence of regulatory authorities that is inconsistent with their support for a nationalization plan?

2. As I noted above, the government already has authority to conduct rescues of failing financial institutions, which makes one think that the critics overstate the contrast between the bailout plan and the nationalization alternative. The bailout plan gives Treasury (new) authority to buy certain securities. Otherwise, the Fed would have to buy and dispose of these securities (under existing authority). I gather that Bernanke does not think the Fed should get into this business and thinks Treasury could handle the job more efficiently. The various descriptions of the nationalization plan that I have seen do not explain why existing statutory authority is inadequate for nationalization at some level. The Fed (and FDIC) already can (in effect) take over financial institutions, as we saw with AIG. Does the nationalization proposal boil down to the parallel claim that Treasury rather than the Fed should be handling this business? Otherwise, can't nationalization or some version of it proceed alongside the bailout, with more AIG-like transactions? If so, what exactly are the nationalizers unhappy about? As far as I can tell, they don't seem to oppose the bailout in principle, just the idea that it is the only thing to do. But no one claims that it is.

Perhaps, critics of the bailout plan are mainly distressed that the Bush administration has been insufficiently aggressive about nationalizing firms, and the whole question of what the statute says is a red herring. From what I can tell, it seems that the Fed and Treasury are taking an ad hoc approach. They want to buy up mortgage-related securities and take over firms, as circumstances dictate. Of course, they can't nationalize in the old-fashion sense of coercively taking over solvent firms, but that course was not taken even in Sweden. In Sweden, it was not the case that all banks were nationalized; only those that accepted the government's terms were, and not all did. These were the insolvent banks—the same type of institution that the Fed and the FDIC can take over under current law. Bottom line: I can't tell whether the critics of the bailout statute are criticizing Congress for failing to compel regulators to take a more aggressive line; are criticizing regulators for failing to ask Congress for authority that they need in order to take the optimal course of action; or are criticizing regulators for failing to take the optimal course of action even though they already have authority to do so. I suspect that the last alternative is most likely, in which case they should leave off criticizing Congress, and stop criticizing Paulson and Bernanke for failing to ask for authority they don't need, and tell us which institutions the Fed and the FDIC should take over now. If it is the first or second alternative, then the critics should point out the gaps in existing law and how they should be plugged.

A final point. Many opponents of the bailout compare it to bailing out the software industry after the Internet bubble popped or bailing out the steel industry or the automobile industry. If it's unwise to bail out industries generally, what's so special about finance?, they argue. But these same opponents have no problem with FDIC insurance or the Fed's historical role of pumping liquidity into the financial system when lending freezes up. The argument that the financial industry should be unregulated was lost long ago, and the argument now is just about means.

	[Eric Posner, October 5, 2008 at 4:07pm] Trackbacks Bailout, nationalization, policy, law. Why do many economists prefer nationalization (or some more modest version where government takes control of financial institutions) to the bailout approach? Under the bailout approach, Treasury purchases mortgage-related securities from banks in a reverse auction. Currently, these securities are not being traded even though they clearly are worth something (they give holders the right to a fraction of mortgage payments, which is worth some amount greater than zero unless homeowners will default immediately and their houses are worth nothing in foreclosure). It is a bit of a mystery why no one will buy or sell them; apparently, they are too hard to value and holders don't want to dispose of them for minimal amounts because their price might rebound. So the toxic waste remains on their balance sheets, making it hard for outsiders to evaluate the solvency of financial institutions and thus reluctant to advance funds to them. There seem to be two distinct objections to the bailout plan: 1. It's inefficient. If Treasury buys up an entire class of securities, it will buy them from solvent institutions as well as insolvent institutions. These solvent institutions don't need help from the government; only the insolvent institutions do. It would make more sense for the government to lend money to the insolvent institutions, or allow them to fail and take on (some of) their liabilities, while leaving the solvent institutions alone. To be sure, if the government pays the "right" amount for the mortgages, it doesn't subsidize the solvent institutions; but then it will also not help the insolvent institutions which will remain insolvent. 2. It's unfair. If Treasury wants to help insolvent institutions, it will have to overpay for the securities. But the government gets nothing in return for this money, which will end up in the pockets of shareholders to the extent that it exceeds what is necessary to return these firms to solvency. Meanwhile, the solvent institutions that sell their securities at a high price get money for nothing, which ends up in the pockets of rich shareholders (of course, not all of them are rich). Under the nationalization approach, the government gives money to institutions in return for equity, which makes the government a part- or full-owner of the institution. The government doesn't buy up healthy institutions, just insolvent or near-insolvent institutions. If these institutions recover, the government makes a profit; if not, at least their shareholders get nothing. Meanwhile, as institutions become healthier, they will become more willing to trade their mortgage-related securities (why, exactly?) or at least they can hold them until maturity without failing. The nationalization approach is more efficient than the bailout because it focuses government resources on the institutions that need help. And it is fairer because taxpayers don't subsidize healthy institutions and they obtain a return if failing institutions recover. I have two questions about this argument. I haven't found answers on the web or in the academic literature, and would grateful be if commenters would answer them or point me to relevant discussions. 1. In both cases, the degree of unfairness and inefficiency is a function of the competence of the government regulatory authorities, not the design of the law itself. If the government pays the correct prices under the bailout, it won't end up subsidizing the healthy institutions; if the securities are worth more in the government's hands, then taxpayers will make a profit when they mature. To be sure, the correct pricing won't help rescue insolvent institutions; it will just make them easier to value; but the government retains the option to lend to these institutions, buy them, or help them in other ways, under its existing legal authority. So the bailout has to be accompanied by equity infusions, but no one has claimed that it wouldn't be. If we can't trust regulators to price securities correctly, that bodes ill for nationalization as well. The government has to price the equity correctly. The government has to supervise the firm competently. And it has to sell the firm eventually. If the government can't determine the correct prices for purchasing mortgage-related securities, why do we think it can determine the correct prices when it sells off businesses? If it charges too little, it will end up transferring taxpayers' money to a class of rich investors. Bottom line: do the critics of the bailout make assumptions about the competence of regulatory authorities that is inconsistent with their support for a nationalization plan? 2. As I noted above, the government already has authority to conduct rescues of failing financial institutions, which makes one think that the critics overstate the contrast between the bailout plan and the nationalization alternative. The bailout plan gives Treasury (new) authority to buy certain securities. Otherwise, the Fed would have to buy and dispose of these securities (under existing authority). I gather that Bernanke does not think the Fed should get into this business and thinks Treasury could handle the job more efficiently. The various descriptions of the nationalization plan that I have seen do not explain why existing statutory authority is inadequate for nationalization at some level. The Fed (and FDIC) already can (in effect) take over financial institutions, as we saw with AIG. Does the nationalization proposal boil down to the parallel claim that Treasury rather than the Fed should be handling this business? Otherwise, can't nationalization or some version of it proceed alongside the bailout, with more AIG-like transactions? If so, what exactly are the nationalizers unhappy about? As far as I can tell, they don't seem to oppose the bailout in principle, just the idea that it is the only thing to do. But no one claims that it is. Perhaps, critics of the bailout plan are mainly distressed that the Bush administration has been insufficiently aggressive about nationalizing firms, and the whole question of what the statute says is a red herring. From what I can tell, it seems that the Fed and Treasury are taking an ad hoc approach. They want to buy up mortgage-related securities and take over firms, as circumstances dictate. Of course, they can't nationalize in the old-fashion sense of coercively taking over solvent firms, but that course was not taken even in Sweden. In Sweden, it was not the case that all banks were nationalized; only those that accepted the government's terms were, and not all did. These were the insolvent banks—the same type of institution that the Fed and the FDIC can take over under current law. Bottom line: I can't tell whether the critics of the bailout statute are criticizing Congress for failing to compel regulators to take a more aggressive line; are criticizing regulators for failing to ask Congress for authority that they need in order to take the optimal course of action; or are criticizing regulators for failing to take the optimal course of action even though they already have authority to do so. I suspect that the last alternative is most likely, in which case they should leave off criticizing Congress, and stop criticizing Paulson and Bernanke for failing to ask for authority they don't need, and tell us which institutions the Fed and the FDIC should take over now. If it is the first or second alternative, then the critics should point out the gaps in existing law and how they should be plugged. A final point. Many opponents of the bailout compare it to bailing out the software industry after the Internet bubble popped or bailing out the steel industry or the automobile industry. If it's unwise to bail out industries generally, what's so special about finance?, they argue. But these same opponents have no problem with FDIC insurance or the Fed's historical role of pumping liquidity into the financial system when lending freezes up. The argument that the financial industry should be unregulated was lost long ago, and the argument now is just about means.