Let Those Banks Fail!

Let Those Banks Fail!
March 4, 2009
Alvaro Vargas Llosa

WASHINGTON—Some big guns on the right have joined the left in calling for the temporary nationalization of America’s troubled banks. Among them are former Fed Chairman Alan Greenspan, Republican Sen. Lindsey Graham, consultant and professor Nouriel Roubini, and former Treasury Secretary James Baker.

They are wrong: Nationalization would compound the problems caused by the credit craze that led us to where we are, kick taxpayers in the stomach, and do in a convoluted way what the market would do swiftly.

The banking system is in a humongous mess. Potential losses by U.S. banks on loans and securities amount to nearly $2 trillion. The response by two consecutive administrations—government-funded loans, capital injections and guarantees—has not inspired confidence. The markets know that the banks are concealing the value of their bad assets by not selling them at the low prices investors would offer.

The reason for not letting Citigroup, Bank of America, Wells Fargo and others go down is, we are told, that credit needs to keep flowing in order to avoid a depression. But that reasoning is backward. Credit is not the father but the child of economic prosperity. Garet Garrett, the intellectual giant of the 1930s, put it like this in “A Bubble That Broke the World,” his classic on the credit craze that led to the Great Depression: “From the beginning of economic thought it had been supposed that prosperity was from the increase and exchange of wealth, and credit was its product.”

It is common knowledge that for years, Americans have lived beyond their means by saving too little and borrowing too much. If this is readily accepted, why is it so difficult to see that a government-induced expansion of credit at a time when American households are finally trying to pay back their debts and save for the future will only prolong the problem?

In January alone, the annual rate of saving in the U.S. was the highest since monthly records began in 1959. That should be a reason to rejoice. Of course, businesses need credit and customers. But there are two ways to get them. One is by bailing out and then nationalizing the banks—and paying a catastrophic price. The other is by letting the financial system purge itself of failed assets and giving consumers a bit of time to replenish their coffers.

Few things give a worse name to the free-enterprise system than offloading bank losses onto taxpayers. The way to solve this crisis is to let “zombie” banks proceed to their beyond, allowing those banks that need restructuring to start doing just that while those in a position to fill the space left by failed institutions can jump in quickly. After all, a majority of the almost 9,000 U.S. banks, including regional institutions, did not engage in credit hanky-panky and would love a chance to increase their market share.

I asked Michael Rozeff, a financial expert and professor emeritus at the State University of New York, if a market solution would interrupt credit. “Federal and state authorities,” he responded, “should immediately encourage new banks to be chartered. These new banks can mobilize the immense amounts of money now locked up in money market accounts and Treasury bills. They can take over consumer loans, auto loans, and mortgage loans from older banks. Credit need not be interrupted.”

Failed banks could be restructured through the FDIC in order to preserve the insured deposits. The creditors and various sound banks would absorb some of the existing branches and the good assets of the bankrupt institutions; the bad assets would be sold at whatever price the markets decided.

Obviously, the shareholders would be wiped out and the bondholders would probably get a “haircut” because the priority would be to protect the depositors—as would happen in the case of a federal takeover, but without the heavy cost.

Those who argue for temporary government ownership point to Sweden as an example of successful nationalization in the 1990s. I asked Fredrik Erixon, a Swedish economist who directs the European Center for International Political Economy, if he agrees. “Swedish policy,” he responded, “had little to do with nationalization: No more than 15 percent of total credit ended up in banks owned by the government.” The government bailed out a bank it already owned (Nordbanken) and bought just one regional bank (Gota Bank).

How can anyone seriously point to Sweden as a model for nationalizing America’s financial system?

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Alvaro Vargas Llosa
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Alvaro Vargas Llosa is Senior Fellow of The Center on Global Prosperity at The Independent Institute. He is a native of Peru and received his B.S.C. in international history from the London School of Economics. His weekly column is syndicated worldwide by the Washington Post Writers Group, and his Independent Institute books include Lessons From the Poor: Triumph of the Entrepreneurial Spirit, The Che Guevara Myth: And the Future of Liberty, and Liberty for Latin America.

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