civil one, “the preponderance of the evidence.” In addition, there is the “micro” issue of precisely when to act.
There is a strong, almost instinctive, preference for swift movement, because past crises have shown how badly banks can deteriorate once they go off the rails. The unwillingness or inability of regulators to move quickly in the Savings & Loan crisis is almost universally believed to have allowed the problem to swell to a much bigger one than if it had been dealt with quickly. Similarly, the experience of Japan’s Lost Decade argues powerfully for confronting the problem and moving on. On the positive side, Sweden is applauded for taking a fairly swift, active approach, which is believed to have contributed to a less painful outcome in its crisis of the early 1990’s than other countries experienced with their crises.
There is a great deal of merit in these arguments, but the timing question is not as simple it may appear at first sight. The necessity, or lack thereof, for widespread nationalization appears heavily dependent on how the economy performs through the remainder of the recession and into the early stages of the recovery. The consensus economic forecast as of February was consistent with a level of credit losses that could be absorbed by the banking system without substantial capital additions beyond what have already been provided or are being made available by the government under current plans.3 The considerably more pessimistic economic scenario foreseen by Dr. Nouriel Roubini would have produced enough additional losses to give serious weight to the argument for nationalizing a number of the major banks.
We will not know for some months which economists are correct, leaving us with a critical question. Should we start nationalizing when and if we discover there is a 30% chance it will prove necessary, a 50% chance, a 75% chance, or what level? This depends heavily on what the harm would be in waiting compared to the damage from acting unnecessarily. Several of my previous papers discuss the pros and cons of nationalization, which have led me to conclude that the downsides considerably exceed the benefits, as long as a bank is still viable without a takeover.
So, what is the offsetting harm in waiting until we see the economic future more clearly? There seem to be five potential dangers, sometimes illustrated by the ramifications of mistakes made in previous crises.
Banks may take foolish risks, particularly on the investment side, in an effort to gamble their way back to health. The Savings & Loan crisis is Exhibit A for this fear. Many of these institutions were effectively insolvent, but allowed to continue operating in the hopes that they could earn their way out of their hole. Since they were already broke, they had little to lose by making high risk, potentially high return investments. If this worked out, the institution was saved. If not, the additional losses would fall on the insurance fund. (This is often referred to as a “moral hazard” issue.)
Please see “Bank Nationalization: What is it? Should we do it?”, for more details.