There are two theories about this latest announcement from the Obama administration about bank capitalization, in which unnamed officials tell a New York Times reporter that converting government-owned shares from preferred to common will stretch public resources at no cost to taxpayers. You could take it at face value, as Paul Krugman does. In this case, the government officials (described as “top economic advisors”—is that Larry on the other end?) are amateurs, unaware that both types of share ownership constitute a capital cushion, for the reasons Krugman lays out. I have questioned team Obama’s judgment in the past, but I don’t think this is likely.
The other explanation is that this is a misdirection play, not-so-secretly concealing a significant step toward nationalization. Real nationalization means control, not just ownership, so the switch to common stock is potentially very consequential. Of course, much of the political and financial establishment is terrified at this prospect, so some other explanation was needed. Hence the (absurd) claim that this conversion is simply a technical move that economizes on scarce federal dollars. Of course, you need a compliant press to pick up the decoy and run with it, and the Times is doing its part. Since no reputable economist would make such a goofy alibi publicly, the article has to be anonymously sourced. Check, check and check.
Should proponents of nationalization be dancing in the aisles, or in the lobbies of their favorite financial institutions? While the political deftness of the latest move can be praised, from a policy point of view it continues the flawed process of piecemeal response. Real nationalization has profound impacts on existing private shareholders and creditors. If it is introduced slowly or one bank at a time, it can set off a panic throughout the system, causing financial chaos and severe political blowback. This is why the stress tests are so problematic: there is no immediate action implied if a bank fails—on the contrary, it has half a year to raise more capital after being branded a proto-zombie. No wonder the banks have been waging a preemptive battle to convince us that they shouldn’t be given a failing grade. A real stress test as part of a coherent, comprehensive policy would result immediately in seizure for those who come up short. The same can be said about the scheme to tiptoe gingerly into nationalization via step-by-step share acquisition: there is too long a gap between the banks’ awareness they being eaten and their actual ingestion. During this pause of several months many nasty things may happen.
For what it’s worth, I repeat here my criticism of nationalization as a strategy for rebooting finance. By acquiring the banks, the government acquires their liabilities. The evidence (amplified by rumored forthcoming revisions in IMF estimates of financial losses) is that the public cannot afford to make these claimants whole. This means in turn a complex round of negotiations over how much of a writedown should be imposed on which classes of claims, a politically messy business with system-level consequences. Until these questions are resolved, the banks and other institutions cannot function in a remotely normal fashion. In other words, nationalization isn’t a solution, only another framework in which to grope for one. Granted, it’s a better framework, but there is a superior option. Specifically, it makes much more sense to use scarce public funds to immediately establish public banking facilities that can finance economic recovery, and to allow existing firms to fail. There would still be an ugly season of resolving legacy claims and parceling out defaults, but at least we would have a working financial system humming in the background. I have also made the case for the long term desirability of a public banking sector modeled loosely on the German Sparkassen, so the “good new bank” idea can also be a stepping stone to a brighter future.