Krugman clarifies his call to nationalize the banks

[ProSense]

March 11, 2009, 8:56 am

Who to nationalize (somewhat wonkish)

John Hempton somewhat misunderstands my point, but that’s OK. I should have been clearer — and he and I actually seem to be mainly in agreement.

I was not saying “nationalize all the banks”; I was saying do what the Swedes did — in tandem with a guarantee on bank liabilities, take the banks with zero or negative capital into receivership. It’s really important that you do this: if you offer a blanket guarantee on the assets of a bank that’s already underwater, you (a) are very likely to take a large hit on taxpayers’ money, without any share in the upside (b) create a huge moral hazard/looting incentive.

Basically, you really don’t want to turn Citigroup into a $2 trillion version of Lincoln Savings and Loan. If you guarantee the liabilities of a stronger bank, by contrast, it’s probably OK even if you don’t take it into receivership.

Let me also say that I think a blanket guarantee without some kind of seizures will just fuel a vast — and justified — populist rage.

Anyway, I think Hempton and I are more or less saying the same thing: guarantee all bank liabilities except for (fill in the blank here), while taking over large banks that are essentially insolvent.

Wednesday, March 11, 2009

Paul Krugman’s false logical step

To my way of thinking Paul Krugman has finally nailed the question as to bank nationalisation that matters. This the money quote:

That said, some decision must be reached on bank liabilities. Sweden guaranteed all of them. If forced to say, I would go the Swedish route; but of course we can’t do that unless we’re prepared to put all troubled banks in receivership. And I’m ready to be persuaded that some debts should not be honored — this is a deeply technical question.

He is absolutely right that this is the critical step in the decision making process is what parts of the banking structure you are going to either guarantee or effectively guarantee. The critical question is not nationalisation.

Sweden could guarantee all banking liabilities because – frankly – their banks were not that deeply insolvent.

We know they were not that deeply insolvent for a few reasons – the best of which is that ex-post the Swedish bailout cost very little (and the Norwegian bailouts were actually profitable for the government).

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But the second part of Krugman’s paragraph contains a deeply troubling false logical step. He says: “but of course we can’t do that unless we’re prepared to put all troubled banks in receivership”.

To see why this is a false logical step you need a little history. A long time ago most the liabilities of almost all banks were deposits. The government guaranteed the deposits by creating the FDIC – it hence stopped crisis driven bank runs. It increased stability in a crisis. However it also allowed financial firms to take huge risks or even be looted (as per Charles Keating). The solution which was adopted (and let lapse of late) was that banks got the guarantee – but were heavily regulated to protect taxpayer interests. There was no need to nationalise the banks simply because you guaranteed the bulk of their liabilities. There was however a requirement to (a) regulate them, (b) assess their capital and (c) take “prompt” corrective action when that capital was inadequate. Prompt corrective action included confiscation. You did not take over banks because they had runs (the purpose of the FDIC guarantee was to stop runs), you took over banks when they inadequate capital.**

Nowadays a lot of banks have the bulk of their assets funded by things that are not deposits. Indeed at many banks deposits constitute less than half the balance sheet.

The old FDIC guarantee can’t stop runs because the run that happens is wholesale – it happens outside FDIC guarantee limit. If you want to stop bank runs the way that the original FDIC stopped bank runs you need to bite the “Swedish Bullet” – that is you need to effectively guarantee everything.

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Krugman’s illogic however does not help the debate. There is a need to guarantee all banking assets – and it should be done provided it is affordable. There is no consequent need to nationalise the whole system – though there will be a need to have a process which will result in nationalisation of some institutions – what I call “nationalisation after due process”.

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2. Krugman

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3. Now-needy FDIC collected little in premiums: With fund going strong, banks didn't pay for decade

Now-needy FDIC collected little in premiums

With fund going strong, banks didn't pay for decade

By Michael Kranish
Globe Staff / March 11, 2009

WASHINGTON - The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.

The Federal Deposit Insurance Corporation, which insures deposits up to $250,000, tried for years to get congressional authority to collect the premiums in case of a looming crisis. But Congress believed that the fund was so well-capitalized - and that bank failures were so infrequent - that there was no need to collect the premiums for a decade, according to banking officials and analysts.

Now with 25 banks having failed last year, 17 so far this year, and many more expected in the coming months, the FDIC has proposed large new premiums for banks at the very time when many can least afford to pay. The agency collected $3 billion in the fees last year and has proposed collecting up to $27 billion this year, prompting an outcry from some banks that say it will force them to raise consumer fees and curtail lending.

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Bair said yesterday that the agency's failure to collect premiums from most banks "was surprising to me and of concern." As a Treasury Department official in 2001, she said, she testified on Capitol Hill about the need to impose the fees, but nothing happened. Congress did not grant the authority for the fees until 2006, just weeks before Bair took over the FDIC. She then used that authority to impose the fees over the objections of some within the banking industry.

"That is five years of very healthy good times in banking that could have been used to build up the reserve," Bair, a former professor at the University of Massachusetts at Amherst, said in an interview. "That is how we find ourselves where we are today. An important lesson going forward is we need to be building up these funds in good times so you can draw down upon them in bad times."

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