Freedomnomics

Article published Monday, February 23rd, 2009, at Fox News.

If We Nationalize Our Banks They Will Become Political Institutions

By John R. Lott, Jr.

Why has the stock market fallen so much as politicians have talked about nationalizing the banks? If this was such a wonderful way of fixing credit markets, wouldn’t you think that stocks would go up?

The discussion might not be academic any longer with reports in today’s Wall Street Journal and elsewhere that the Obama administration is talking with Citibank about taking over as much as 40 percent of the company’s stock. Such a move would make the government not only Citi’s largest shareholder, by far, but it would effectively give the government complete control.

Politicians from Senate Banking Committee Chairman Christopher Dodd (D-Conn.) to Senator Lindsey Graham (R-S.C.) support nationalization. Democratic economists such as Joseph Stiglitz and Paul Krugman, and Alan Blinder also support it. Even former Federal Reserve Chairman Alan Greenspan supports a very limited nationalization. President Obama has already been on the record saying he opposed nationalization but now the state of negotiations with Citi has apparently already changed his mind.

Nationalization is being sold as necessary to help the banks but some banks were forced to take bailout funds over their objections last fall. Now some banks such as Bank of America are objecting to this new “help.” And who can blame them? Bank of America has continued to remain profitable despite being coaxed by the Federal Reserve to take over troubled financial institutions.

In the fall the government claimed that banks had to accept bailout funds because those that didn’t would stigmatize those who did. The argument made little sense then because the money given to the banks was claimed to have corrected their problems so there should have been little remaining concern.

For those financial institutions in trouble there is a simple solution available that we use for firms all the time — bankruptcy. If necessary, deposit insurance is where the government could be using the trillions of dollars it wants to spend. Bankruptcy judges are quite sensitive to keeping firms functioning and there is no reason why they couldn’t handle these financial companies as well.

Yet, there are strong reasons to believe that the losses from politicizing banks could be huge. Politicization may not only hurt the banks, it might also effect their customers.

Just the mention of nationalization last week caused stocks to fall but bank stocks collapsed. Bank of America’s shares fell 36 percent after Senator Dodd announced on Friday that nationalization might be necessary. Citigroup’s stock fell by 22 percent to $1.95 on Friday.

Why did just a mere mention of nationalization cause such a strong reaction? Because when governments around the world have bought an ownership stake in companies, the desire to run firms efficiently goes out the window. Studies consistently find that even partial government ownership reduces firm profitability. We once had a national bank in the U.S. — the Bank of the United States — and President Andrew Jackson eliminated it because the bank funded politically connected businesses.

Is that really a surprise when politically powerful Congressmen grant defense contracts to companies who have a lot of workers in their congressional districts ? It is bad enough for national defense but is that the way we want our banks to be run, too?

A recent and all too typical example involves Airbus, the giant European aircraft maker. For example, the company’s CEO resigned in 2006 complaining that political concerns took precedent over what made financial sense. Germany, France, Spain, and the U.K. all own shares in the company. — That means that manufacturing plants and jobs are not distributed in ways that make the most sense economically but to ensure that each country gets its “fair” share of highly paid jobs all subsidized with taxpayer money.

Here is one reason that the Airbus CEO resigned:

“The contribution of the United Kingdom taxpayer alone towards the A380 program is 530 million [British pounds]. In return for that, Broughton [in England]Ögot to make the wings. But it also means that each completed set of wings has to make a remarkable journey to the final assembly site in France by way of container ship, river barge and specially adapted road trailer. With the main fuselage having to travel from Germany and the tailfin from Spain, no wonder Christian Streiff, the man who was drafted in to head Airbus in July [2006], commented that there must be a simpler way.”

Putting the wing factory next door to where the fuselage was made would have saved a lot of money — money that could have paid higher wages or encouraged more investments and expanded production. Governments could even have taxed away those savings and used them for everything from education to medical care. But politically it was more important that certain constituencies get particular jobs.

This wasted money not only means financial loses for the firms, it also means a poorer country.

But with banks there is an even worse possibility. Over the last couple of decades the federal government used regulations to forced banks to give mortgages to people the banks thought were too risky — people who couldn’t make down payments and may have only had income from welfare. With the government owning the banks, banks may be asked to fund all sorts of politically desirable borrowers. The problem now is that with government ownership — instead of just regulations — the political pressure might be much harder to track.

Economists have also argued that government owned companies frequently charge less than the cost of their products — in other words, they engage in predatory pricing. In this case, nationalized banks backed by the federal government might charge lower interest rates than private banks, forcing the remaining private banks out of business.

The point isn’t that banks are bad investments. The problem is that nationalization will make banks into bad investments.

Capitalism might not be liked very much by those on the left, but capitalist countries are wealthier than socialist ones for a reason and that wealth has allowed governments to provide previously unheard of help for the poor. The reason? Incentives matter. Government has neither the expertise nor the incentive to run companies efficiently.

*John Lott is the author of Freedomnomics and a senior research scientist at the University of Maryland.

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