Guest Post by Gordon

In a recent blog post, Duy and Magud said that current discussion about banks’ balance sheets has “converged” to either offering government guarantees or creating a “bad bank.”

I don’t know where they get their ideas of “current discussion” from, but they’re obviously not listening very hard. Two options that have escaped their attention as far as banking rescue goes are nationalization and the creation of a new, National Bank. They’ve obviously missed Stormy’s post, as well as several others.

Both nationalization and the creation of a new National Bank have as their objective the freeing up of banks to act like banks again, and lend to creditworthy borrowers in the “real economy.” Anybody who thinks that this isn’t necessary might read this blog post on the credit crunch.

Nationalization has been widely called for. There are two possibilities: The government buys the bank or seizes the bank’s assets as per FDIC procedure with bankrupt banks in “normal times” – only this time it doesn’t on-sell the assets, but instead it continues to operate the bank. Either procedure leads to Government-owned and operated banks.

Creation of a new bank doesn’t involve purchase or seizure of sick banks’ assets. The Government simply initially capitalizes a new bank that is run as a commercial bank and makes loans to the creditworthy in the “real economy.” The National Bank pays an agreed and reasonable rate of return to the Treasury on its capital. It will work directly and immediately to help end the credit crunch, giving people a bank they can confidently lend to and make deposits in. Just to fix the idea in people’s minds, I originally called it “The Commonwealth Bank of the United States” when I first advocated the idea back in March last year. People also refer to the idea as simply a National Bank or a Government Bank. It has even been called a “Good Bank,” in order to point up the difference from “bad bank” proposals.

Prof. Buiter (LSE)[here and here] and Prof. Romer [here] (Stanford) have now presented proposals for a National Bank. Prof Buiter notes (see second linked post) that Prof. Stiglitz has given the idea a passing nod of approval. Both Buiter and Stiglitz have previously supported nationalization, so it’s interesting to see their ideas moving forward.

It’s worth noting that Prof. Buiter’s proposal is complex, having features of nationalization and “bad banks” in it as well. He is obviously trying to work out the futures of the existing “troubled” banks at the same time as proposing a new, National Bank (or National Banks, because his proposal could involve several). His ideas are interesting but I think need some more work, and I won’t go into details here.

One of the problems with nationalization is the need to recapitalise. George Soros has estimated that $1.5 trillion will be needed to recapitalize existing sick banks. That is a lot of money, but the real issue is that Governments going the nationalization route don’t have any choice. Solvency is solvency, its arithmetic of assets and liabilities, and nationalization commits a government to paying whatever is necessary. Creation of a new National Bank allows the Government to make an independent decision about the amount of initial capitalization. Then, as Prof. Romer says, it allows the new National Bank to (modestly) leverage that initial capital:

The government has $350 billion in Troubled Asset Relief Program (TARP) funds that it can use to encourage new bank lending. If this money is directed to newly created good banks[sic] with pristine balance sheets, it could support $3.5 trillion in new lending with a modest 9-to-1 leverage.

Some people also are troubled by the idea of a National Bank being a toy for politicians. This objection would apply equally to nationalized banks, of course. To avoid this, we must ensure that the National Bank is run at arm’s length from Government, just as Social Security is run at arm’s length. Its accounts would need to be audited, and Congress would probably want to approve the audit (it put up the initial capital). Some people will always say Government can’t do this, but the examples of SS and the New Deal programs show that Government agencies can be run in a trustworthy and transparent way.

The real issue with “moral hazard” is ensuring that the new National Bank is run conservatively. Its charter needs to be written in a way that allows it to do all the things that a commercial bank can do within reasonable risk parameters. Credit cards at reasonable rates? Sure. Loans for cars and house improvements? Absolutely. Student Loans? No problem. Business loans? Of course. But all these lines of business need to be managed so that credit is extended to the creditworthy.

Speculation in risky, high-yielding derivatives would be out, as would credit for deserving but not really creditworthy applicants. The National Bank shouldn’t try to do the things that the Government. is currently preparing to use fiscal policy to do. It isn’t a stimulus package. You may need to be careful, but I don’t think it’s impossible. Is the TARP “moral hazard” any less?

A third problem that is often raised is the sheer logistical difficulty of starting up a new National Bank from scratch. I like to point out how quickly and efficiently Americans can set up campaign offices during elections. Space is rented, furniture and equipment are rented and moved in, staff are hired and volunteers mobilized all in a few days. And the US Federal Goverment has a big existing network of offices nationwide which should make the problem easier. Maybe a National Bank would be difficult to set up in places which aren’t so good as logistics, but I just don’t see this would be a problem if the US Government really wanted to do it.

Some proposals envisage the privatization of a National Bank at some time in the future when “normalcy” has returned. I don’t. I would advocate a continuing Govt.-owned Commonwealth Bank of the United States. First, because privatizing a National bank is itself an exercise fraught with “moral hazard”. It would be too easy to sell it off cheap to political connections. Secondly, because a continuing Government. bank run conservatively and transparently would contrast dramatically with the murky and opaque bank management practices which have led to the current debacle. This would, I believe, assist the regulatory reforms that will also have to be made but which will take a longer. The National bank would set a benchmark. Call it “regulation by example”. Thirdly, because it would provide a continuing source of income to the Nation through the Federal Government. Why unload a good and secure investment?

What would happen to existing “troubled” banks? I don’t know. Maybe the Federal Government will find a way to rescue them. Maybe the new Geithner plan will eventually work. The National Bank will be out there taking deposits and lending in the meantime, but not speculating in risky derivatives or making too-risky loans.