Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

08 September 2011

Excising our Metastatic Cancer of Finance: Temporary Market-Based Nationalization

Over three weeks ago, I wrote about our metastasizing financial sector. If not removed, its all-consuming cancer will kill our national economic recovery.

I left that post up while on a trip abroad because I believe it to be one of the most of important I have written this year. We cannot restore our economy without first getting our rogue financial sector under control. Our markets seems to recognize this point; they have sent financial stocks into a tailspin. They know who is at fault.

The horse of financial reform must precede the cart of jobs. We cannot create new jobs, let alone in manufacturing, while we seduce the best minds of yet another generation into useless paper-shuffling with the promise of obscene, undeserved and early wealth.

However attractive getting rich quick from financial legerdemain may be to individuals, it creates no real wealth for society. On the contrary, the gambling and swindling that have become the hallmarks of our rotten financial sector, especially in derivatives and commodities, threaten to subvert our entire economy once again.

This time, their metastasis likely will be terminal. Nowhere in the world is there enough government money to bail the banks out again. Not in North America. Not in Europe. Not in Japan. And not even in China.

So when I said that reforming finance, not jobs, is job one, I meant it. There will be no employment recovery, and no relief from a lost decade for mature economies in North America, Europe and East Asia, unless those economies collectively hold their banks accountable and reform their financial systems. The cancer must be removed, or the patient will die.

But how to excise it? In my earlier post, I promised solutions. Here I propose one.

To be effective, the solution must be radical. Last year’s so-called financial reform, still under sustained attack by armies of lobbyists in the regulatory process, just won’t work. It’s too little, too late, too weak, and too vulnerable to subversion by the very powers it seeks to control.

The basic problem is concentration of economic power. Simply put, our big Manhattan banks have taken control of virtually every lever of power in our society. We must cut them down to size, by a least a factor of three. Otherwise, they will stay in control of our political process and remain “too big to fail.” The ultimate consequence, in the inevitable collapse resulting from unrestrained financial “innovation,” will be a financial flood to big to bail.

Regulation alone cannot do the job. The problem is the big banks’ size. That size carries with it enormous political and commercial power, plus an implicit government guarantee against loss and therefore immunity from market forces, which increases moral hazard.

Our big banks are in the market but not of the market. They subvert capitalism itself, while paying lip service to market principles for consumption by naïve voters and legislators.

The goal of financial reform should be to split up the big banks in three ways. First, we should separate their commercial banking operations from their investment banking and proprietary trading, including trading in derivatives and commodities. The split should be practical and real. Then we should back it up with legislative prohibitions against recombining and cross-ownership, along the lines of the old Glass-Steagall law but more nuanced and stronger for our modern age. Perhaps we should also separate retail (personal) banking from commercial banking, the better to protect consumers and stem the recent tide of high-handedness and swindling.

But how to reach these goals? Our antitrust laws are impotent. They only forbid anticompetitive mergers and acquisitions, and then only those that have not yet become stale or accomplished facts. Our laws give government no power to split up banks too big to fail. Furthermore, our Constitution forbids impairing the obligations of contracts or taking private property without just compensation. And longstanding political and judicial culture prohibits government from messing with the private economy in any significant respect.

In the last century, there was talk of nationalizing the banks and treating them like public utilities, monopolies over money, if you will. Many nations did just that, including our European trading partners. But, however temporary or interim it might be, “nationalization” has the ring of socialism and would evoke storms of protest and interminable litigation here. Nationalization by decree therefore would be impractical and likely politically impossible.

So are we stymied? I don’t think so. What about “market-based nationalization”? Why can’t the government, perhaps through the Fed, simply buy up the big banks at market prices, dismiss management and the boards of directors, hire teams of finance and economic experts to unscramble their eggs, and sell off the pieces to private investors, perhaps even at a profit?

The crux of the matter is leverage. The big banks have trillions of assets, which the government could never buy on its own. But, as a result of their gambling, swindling and general mismanagement, they also have trillions of liabilities and risks. The net result is a pittance by the standards of our recent bank bailouts.

For example, as of today (September 8, 2011) Morningstar reports Bank of America’s market capitalization as $ 74.9 billion. Buying control would take about half that, or about $37.5 billion. By recent standards of bank bailouts, that is pocket change.

A leak or announcement of the government’s intention might cause the market price to rise in anticipation of a government purchase. Or it might cause the market price to fall even further, in anticipation of a breakup, a loss of the implicit government guarantee, and/or further regulation. But in any event buying control would be orders of magnitude cheaper than bailing out another failure, even without accounting for the expected income from selling off the pieces later.

By buying, splitting up, and selling off the top five or six banks, the government could recreate a rational, competitive banking systems in two ways. First, it could sell off the retail banking, commercial banking, investment banking and trading (including derivatives) operations separately. Second, it could create regional diversity and restore community banking by selling off regional or local offices separately. In other words, the government could re-create a vibrant, highly competitive banking system like the one that existed before the most recent waves of mergers made our big banks “too big to fail.”

None of this would involve “nationalization” in the old twentieth-century sense. Government intervention would be through securities markets and temporary, only for the time necessary to analyze the banks’ operations, figure out the best way to unscramble the eggs, and sell off the pieces.

Private banking investors would have no choice but bid if they wanted a piece of the action, because, at the end of the process, none of the big banks would remain. Gone would be their implicit guarantees, their increased moral hazard, their entitlement to bailouts, and their political and economic dominance. Market forces would resurge and rationalize our finance sector in accordance with classical capitalist economics.

How would the downsized banks make big deals? The same way they did before the latest waves of mergers made them “too big to fail” and caused market failure. By syndication. Banks would have to collaborate on big deals, bringing the advantage of “more heads than one” to deals involving significant financial risk. Thus the downsizing would reduce systemic risk as well as moral hazard.

Competition would benefit. Local and regional control would benefit. The banks would no longer have enough money and clout to buy legislatures and corrupt the political process. And regulation of the separate sectors (retail, commercial, investment and trading) could be calibrated separately to avoid regulatory overkill. Once the government had downsized the biggest tumors, market forces would do the rest.

This would be a bold, radical plan. But it would work without damage to fundamental free-market principles. It would restore market forces to a sector that long has eluded them. And the end result would be a highly competitive, much smaller and more rational financial sector without the power to corrupt government, command bailouts and make the public pay for its mismanagement and mistakes.

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