Politics and Banking Are A Dangerous Mix


Paul Krugman’s call this morning for nationalization of failed megabanks like Citigroupa and Bank of America makes a brisk and refreshingly clear headed case against the fatal mistake of keeping otherwise insolvent banks afloat. But now that the idea of seizing the failures is taking hold, it’s time to start asking the tough question about what measures we need to take to avoid making the banking catastrophe even worse.

As Gerald Driscoll of the libertarian Cato Institute points out in today’s Wall Street Journal, the steps taken by Sweden went far beyond seizing the failed banks. The Swedish government under conservative Prime Minister Carl Bildt enjoyed an unusual level of support from even his political opposition, and the resolution was handled professionally rather than politically. This support allowed his government to aggressively write-down assets, squeeze borrowers and conduct a kind of banking triage.

Importantly, Sweden seems to have avoided the politicalization of banking. This was a rare phenomenon. Government ownership of financial institutions typically leads to political control, which is a disaster. Loans are made to please political sponsors, with businesses favoured for political reasons rather than because they are profitable. Strangely, we’re still not sure how Sweden managed to avoid this.

Figuring out how Sweden avoided having special interests capture the banking industry and the government agencies controlling banks needs to be a top priority. Already, we’re headed in the wrong directions. The banks are being pressured to take it easy on indebted homeowners, while Sweden squeezed them. Politicians are trying to put in place corporate governance structures–such as “say on pay” provisions–favoured by labour unions. We can expect banks to be pressured to lend to environmentally friendly businesses over less friendly businesses.

Here’s how Driscoll explains the danger:

The contrast with the current U.S. crisis could not be sharper. From the beginning, the handling of the U.S. crisis has been politicized. The partisanship is as toxic as the bad assets on bank balance sheets. Both parties are coming up with schemes to impede the process of foreclosing on homeowners who can’t afford their homes, which would get those homes into the hands of new owners who can afford them. Does anyone believe that a government bad bank will squeeze homeowners? To ask the question is to answer it.

Moreover, we know how the government runs financial institutions — consider Fannie Mae and Freddie Mac. Or IndyMac, whose management by the FDIC has been criticised for inflating the rescue costs through its liberal loan-modification program. A money-centre bank in government hands would become a conduit for politicized lending and grants disguised as loans. That’s what’s happened at Fannie and Freddie. The government would never let go of its political ATM. You might as well consolidate such an institution with the Fed from the outset.

This is perhaps the most urgent problem facing us: can we constrain the forces of politicalization the way Sweden did? Or will we let rent-seeking special interests turn bank nationalization into a bonanza?

Hopefully, our answer won’t just be: the Swedes are different. In many ways they are different. They have managed to make the kind of cradle to the grave welfare state that wreaks havoc on other economies more or less work for them. Maybe they have some homebrewed advantages that allow them to avoid the disastrous consequences of state intervention. What if we can’t do nationalization right because we aren’t Swedish enough?

Shudder. Before coming to that grim conclusion, we might as well explore this question more. What did the Swedes do that we might be able to imitate? Other than being more Swedish, which isn’t an option in the short term.

Importantly, it seems that a part of successful nationalization involves actually breaking up and shutting down bad banks. The good assets and business lines need to be quickly sold off, while the bad busineses just need to be shut down. The models of AIG and Fannie and Freddie should be counter-examples: highly politicized institutions that have managed to convince the government to expand the financial aid they receive rather than liquidating them.