Arguments Against Nationalisation, Part 2: Baconian Equivalence

Probably the most common argument I have heard from influential Irish commentators when they argue against nationalisation is to quickly dismiss it on the grounds that it simply does not help in “solving the problem” or reducing the cost of the banking crisis for the taxpayer.  Yesterday’s Irish Times article by Scott Rankin provides one example of this argument.  Let me provide three other examples.  Here are two examples from Prime Time on March 19.

First, Brendan Keenan of the Irish Independent  (One minute in):

I’d also be very reluctant to nationalise them because, you know, that doesn’t change the onus on the taxpayer.  It just means you have to run the banks as well.

Second, from the same show (about 3.15 in), here’s David McWilliams:

It doesn’t matter whether we nationalise or not. We still have this big dilemma, which is in the last five years we lent lots of money to people in property we shouldn’t have done.  Now, no matter how you skin this particular cat, you can’t get away from it. So, it makes no difference who owns it at the end of the day.

And finally and probably most importantly, here’s Peter Bacon from Morning Ireland on Thursday (about 6.50 minutes in responding to a proposal from some UCD Professor that the banks should be nationalised): 

It would change the name over the door, so to speak, from private shareholder to government.  The losses that I’ve spoken about will still sit on the balance sheet.  My fundamental point is, look, nationalising it doesn’t change it.  It might move it.  It might change the name over the door.  The fundamental  problem is that the balance sheet of Irish banks are sorely compromised.  You nationalise it and then you would still have to deal with it. 

Because Dr. Bacon is its most important advocate, I hereby dub this idea the Baconian equivalence proposition.  I have tried on a number of occasions to explain why the decision to nationalise or not matters greatly for the potential costs to the taxpayer.  But perhaps these explanations have used too much technical banking terminology, so let me have a go using a simple metaphorical story. 

Two businessman, old friends, meet in a bar.  Mr. A says “Hey dude, I’m in big trouble.  My balance sheet says my business is worth €20 million but actually I’ve made some really bad investments and when the accountants come in next month, they’ll see that I actually owe €5 million more than I have in assets.”  Being old friends, Mr. B wants to help Mr. A.   Let’s consider two possible reactions:

(a)    Ok, I’ll help out.  I’ll pay off your debts of €5 million. And then I’ll invest €20 million in your business to get it back in healthy shape.  But, look, there are limits to my charity.  You’ve run your business into the ground and I’ll only do this for you on condition that I own the new company worth €20 million.

(b)   Ok, I’ll help out.  Here’s €25 million for you.  And you know what?  I couldn’t be bothered taking an ownership stake in your company, so just carry on and keep up the good work.

Needless to say Mr. B is the taxpayer and (a) represents nationalisation while (b) represents the opposite extreme of re-capitalising without taking any state ownership stake (I know that this is not being proposed—this is an allegory to illustrate a point).

Examining this story, we can see that what is certainly true is that the amount of money paid out by Mr. B to fix the company’s problem is €25 million in both cases.  It is perhaps this germ of truth that underlies the Baconian equivalence fallacy.  However, to say that the Mr. B is equally well off in the two cases is clearly wrong.  In case (a), bailing out his friend had a net cost of €5 billion because he now owns a company worth €20 million.  In case (b), bailing out his friend cost him €25 billion.

Getting back to reality, it appears likely that our major banks are insolvent.   Taking over these banks will cost the taxpayer money because we will be inheriting assets from these institutions that do not cover their liabilities (the €5 million loss in the above example).  But the crucial conceptual mistake being made by BE proponents is to see the additional funds required to bring the banks back with assets above liabilities (the €20 million in the above example) as a pure cost to the taxpayer.  As I outlined in my four part plan, it is crucial to realise that government funds invested in re-capitalising nationalised banks can be recouped later when the banks are privatised.

On this last point, it is probably worth emphasising that the market value at which a bank’s equity trades on the stock market is not the same as the book value equity (the book value of assets minus liabilities) that I have been discussing.  Normally, banks trade on the stock market at a decent premium over book value, reflecting the fact that not only do their assets exceed the liabilities, but the holders of bank shares will be entitled to future dividends generated from profits. 

It is likely that tighter regulation will mean that the premium over book value for banks will be lower in the future than the levels that prevailed in the past.  But there is little reason to think that well capitalised privatised banks, cleansed of bad loans and with a strong retail base, would not sell for at least book value, and this would ensure that government re-capitalisation funds will eventually return to the government coffers.

18 thoughts on “Arguments Against Nationalisation, Part 2: Baconian Equivalence”

  1. Karl, excellent series of posts.

    But I think your example here is a distraction. As you say, nobody has proposed recapitalising without compensation to the government. You are absolutely right that closest possbile attention has to be paid to ensure the government does not overpay for the assets — I don’t think anyone disagrees. (I include Patrick’s propsal here with Philip’s proposed modeification of terminology.)

    From that point on, I think the debate is best served if we proceed on the assumption that the government pays expected value and then ask which arrangement has better incentive and risk properties from the public interest point of view. Otherwise, the bail out and organisational questions get tangled.

    At present, the market value of bank equity is close to zero. If after the asset purchases (and presumably the government taking a majority equity stake) the market value of the remaining stake owned by the original owners is still close to zero, then I do not see how the government has bailed the bank owners out. Repeating myself, we can then focus on the relative governance, diverstiture and risk advantages of the contending alternatives.

  2. If we nationalized all the banks how much shareholder and other forms of equity, that are not guaranteed, is left?

    What reason could the government have for not using all of these funds to absorb the first tranche of losses though a full nationalization and restructure of the banks.

  3. Thanks John. I fear, however, that you are being a bit optimistic here about the level of public understanding of these issues. While nobody is saying the govenment should not get an equity share (the €7 billion has already been agreed) a large number of commentators are saying that the value of the discount paid for the loans does not matter because the total amount needed for re-capitalisation is the same either way. Read Rankin’s article, for example.

    The purpose of the example is to illustrate that, conceptually, this position requires those that adopt it to also say that there is no difference between (a) and (b). Stylized examples like this are one way of illustrating general principles that sometimes get obscured by the bells and whistles associated with realistic discussion.

  4. The trouble with the stylized example is that it doesn’t quite fit the banking context. Because of the guarantee, B has already agreed to cover A’s debts. The NAMA logic could be seen as B saying that since it’s A’s bad assets that thus pose a threat to B, B should just directly take them over once whatever excess cash A has to cover the debts is exhausted. And B thinks he has a better chance of running an entity specialized in one type of asset rather than running A’s entire operation.

  5. Karl, this is very informative. Thank you.

    If the public at large are not subsumed into this dialogue soon by the Government there will be a very confused and angry electorate awating them in June. The scale of what is being considered is awesome (50% of GDP) and even more awesome for individuals and families traumatised by the further confiscation of income in the Budget, recently unemployment or otherwise economically threatened. Indiciative results need to be evident quickly enough to demonstrate the credibility of the chosen approach.

    When the true extent of the incidence of toxic loans at each of these banks is ascertained, surely the approach would be to reduce the exisitng equity to the extent of these losses, which in some instances could be zero, or greatly below zero.

    The existing shareholders could be offered the opportunity of raising new capital privately and if they succeed they bank remains a PLC. This would mean that the State is not, at the outset, approaching this matter on the basis of ‘one size fits all’.

    This was the case with respect to at least one Scandinavian bank in the 1990’s crisis. But if they fail to raise new equity, then the Government ought to obtain equity for its contribution and, if it is the sole shareholder, the bank is nationalised. Perhaps this approach would facilitate the sale of Government equity (privatisation) more quickly than would be the case of a business that suffered the institutional consequences of long-term nationalisation.

    Another matter that needs an airing is the capacity of these banks to return to profitability within an acceptable timeframe and otherwise, merged, disposed of or closed. It would be outrageous to maintain a no-hoper on tax-payer life support for longer than is reasonable.

    The existing boards of these banks need to be vigorously overhauled as a feature of this bailout.

    A further point that I am curious about concerns the impact of the personal mortgagees’. The perception that I have is that the focus of attention is on the very large amounts owing by developers (speculators). But the consequences of lending to individuals amounts of money that are far greater than their sustainable income can service and lending sums greater than the initial value of the mortgaged property must be about to haunt the economic system. Commentators frequently mention that Ireland is untainted by the US inspired sub-prime lending debacle but the utter breakdown of financial law and order over the past several years must almost mimic sub-prime. Our GDP grew by 26% between 2004 and 2008, even allowing for its tapering last year. But private sector credit grew by 97% to almost €400 billion when the party was in full swing, dungarees were exchanged for pin-stripe suits and and Hiace vans for Aston Martins!

  6. I find myself reluctantly in agreement with you Karl.

    Another supporting argument for nationalisation is set out in a thought provoking note by Paul de Grauwe (writing about the ‘four deflations’ we now face – over at Euro Intelligence http://www.eurointelligence.com/article.581+M5a44f3fb3ec.0.html). He makes the point that the good bank/bad bank arrangement (similar to the NAMA approach) assumes that the privately owned ‘good bank’ will start lending ‘normally’. But what if they don’t? What if their incentives are to curb lending (and the risks that go with it in a still moribund economy) in order to appease risk averse shareholders?

    In such a scenario the taxpayer has been left holding the baby … without any alimony. Seems like another reason for the nationalisation-then-privatisation model you propose.

  7. Karl, I now see better where you are coming from (sorry for my slowness).

    First off, you win the argument with Rankin hands down: Backdoor recapitalisation through overpayment is indeed a terrible idea for the taxpayer.

    I now see you are making the empirical claim, in part informed by very the existence of arguments such as Rankin’s, that the government is likely to overpay outside a nationalisation context. In that case, my proposed separation — pay expected value and then take fair compensation for recapitalisation — does not work.

    Can you envision any mechanism for setting the asset transfer prices that would reduce your expectation of overpayment?

  8. John,

    Yes, that’s a fair summary of my concerns. More specifically, one of the reasons I’m concerned that we will end up overpaying is that even those involved in the process who understand perfectly well that the arguments cited in my piece are without merit, may still be willing to run a scheme which overpays because they are convinced that nationalisation is A Very Bad Thing.

    Part of what I’m trying to do with these posts is help convince people that, while hardly desirable in normal times, nationalisation may just be the best of a set of bad options, and that — properly managed — it can produce an efficient outcome that minimises cost for the taxpayer.

    If the government is willing to really consider nationalisation, then it may run a fair NAMA valuation process. If they are determined to rule out nationalisation, then there are lots of accountancy tricks that can be used to price these loans at far more than they are worth (Remember the PWC report’s claims that all of the Irish banks were well capitalised?)

  9. Karl
    The Baconian equivalence is current state thinking – that is the market for banks remains largely as before. There are two problems with this. The first is the current high risk profile of Ireland’s economic health and banking’s unrealised exposure – the insolvency & reputational capital problem- and the wider global redefinition or narrowing of banking issue. If banks are to be curtailed required to maintain higher capital buffers, provide recourse buffers, with maximum leverage and funding limits presribed in rules then profitablity expectations will have to adjust. There will be a new market for effectively regulated, well capitalised and well run joint stock banks. But until the economy recovers and with it banks and until the global definition is applied, Irish banks need to restructure within a safe haven – but and this is a big but – does the state have the willingness and capacity to provide the equity required in the short term while waiting for any new order to bed down ?

  10. None of which means that those banks will be able to lend more money.

    How do we ensure a smaller, healthier banking sector?

    Let’s amalgamate some of the credit unions? Build on what is regarded as sound and the rate of growth may be surprizing. But it does require a government licence.

  11. @PatD Pat credit unions propose an interesting alternative. Shoe horning the bigger ones into a federalist credit co-operative form aka Rabobank etc would on paper propose a consumer/micro business banking alternative but would require a viable core – suppose EBS were to become the core around which the structure is built ?
    In any event government it seems will have to come up with a namaesque solution to resolve quite serious liquidity issues stemming from hefty losses in investment portfolios – the quid pro quo I would suggest is consolidation of those healthy enough and closure of the balance within a structure that makes sense.

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