Caveat Emptor

It is sometimes the task of those commenting upon government policy to pragmatically limit consideration to those options which are politically possible, and palatable to the vagaries of public opinion. These are the constraints in which public debates takes place.

Government intervention in the market caused the current financial crisis. In the US, artificially low interest rates created the credit which was released to sub-prime borrowers who could not afford it. Politicised lending is recognised now as a major source of the toxic assets plaguing today’s banks. However, the best course of action available today to the Irish government could be the most strenuous government intervention – in the form of nationalisation.

These banks are over-leveraged. It is now known that the level of lending in the global economy was unjustified by the real value of the assets possessed by them. This money needs to come from somewhere, and it’s not coming from investors or other sources. Thus, government intervention is required to prevent further crisis and unfreeze the credit markets. This could take the form of simple recapitalisation or nationalisation and the forced purchase of problem banks.

Unfortunately, the credit market will not unfreeze itself. Meanwhile, businesses are closing and fewer opening given the lack of access to capital. Although the collective interest would be served by releasing credit (allowing the creation of new jobs through enterprise and entrepreneurship), each bank seeks only to preserve itself and is unwilling to take the risk of releasing credit. The current market slump is self-perpetuating. Without centralised control of the banking sector, the necessary counter-cyclical lending will not take place

Expansionary fiscal policy can only go so far to artifically raise domestic demand for goods and services, and attaching conditions to recapitalisation is notoriously difficult. Banks are fearfully hoarding credit. Those institutions which receive government bail-outs are especially eager, so that they can pay back the government and remove its meddling influence. Thus, recapitalisation is completely failing in its objective to unfreeze the credit markets. This can be empirically verified.

Investors are also sceptical. Unfortunately, the equity markets just don’t believe that the government is really providing enough capital to banks to make them viable again. The problem stems from toxic assets, like mortgage-backed securities. Their value is entirely unknown. This is why share prices continue to fall even after recapitalisation. The government is unable to reliably support the figures that they’re providing, and convince investors that the toxic assets are accounted for. Thus, these institutions will be unable to raise money from the equity markets until confidence returns to the banking sector. They would much rather sit on the toxic assets until their value is known.

If the government adopts a policy of nationalisation rather than simple recapitalisation, they can force banks to release the necessary credit effectively and aggressively write down the afore-mentioned bad assets. Gerald O’Driscoll of the Cato Institute expresses anxiety that the politicised lending which caused the problems in the American banking sector will inevitably creep into any nationalised system. Such concerns can be addressed by making the management of the banks which are nationalised independent of government policy, like the Bank of England.

Nationalisation is better from the perspective of the taxpayer. Rescuing the banking sector will require sacrifices. If they are to stump up the cash and accept the risk, it’s not fair that the return on that investment goes to someone else. Thus, temporary nationalisation along the lines of the Swedish model will ensure that the taxpayer gets maximum value for their money. They should expect no less.

First published as “Recapitalisation not enough in the current crisis” in The Record (3rd of March, 2009).

© The Free Marketeer 2009

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