[Marxism] FT opinion calls for nationalization

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Temporary full state ownership is only solution
By Paul De Grauwe

Published: October 9 2008 19:06 | Last updated: October 9 2008 19:06

The essence of what banks do in normal times is to borrow short and lend long.
In doing so, they transform short-term assets into long ones, thereby creating
credit and liquidity. Put differently, by borrowing short and lending long,
banks become less liquid, thereby making it possible for the non-banking sector
to become more liquid; that is, have assets that are shorter than their
liabilities. This is essential for the non-banking sector to run smoothly.

This credit transformation model performed by banks only works if there is
confidence in the banks and, more importantly, if banks trust each other. This
confidence has now evaporated and, as a result, the model fails. The
generalised distrust within the banking system has led to a situation where
banks do not want to lend any more. That means that they continue to borrow
short but lend equally short; that is, acquire the most liquid assets.

The result is a massive destruction of credit and liquidity in the economy. The
non-banking sector cannot borrow long so as to acquire liquid assets that they
need to run their business, because banks do not lend long anymore. This risks
bringing the economy to a standstill. A depression is looming.

It is important to realise that this liquidity crisis is the result of a
co-ordination failure: bank A does not want to lend to bank B, not necessarily
because it fears insolvency of bank B but because it fears other banks will not
lend to bank B, thereby creating insolvency of bank B out of the blue. Thus bank
lending comes to a standstill because banks expect bank lending to come to a
standstill.

How to get out of this bad equilibrium? There is only one way. The governments
of the big countries (US, UK, the eurozone, possibly Japan) must take over
their banking systems (or at least the significant banks). Governments are the
only institutions that can solve the co-ordination failure at the heart of the
liquidity crisis. They can do this because once the banks are in the hands of
the state, they can be ordered to trust each other and to lend to each other.
The faster governments take these steps, the better.

Government interventions have consisted of recapitalising banks. These have not
worked. The main reason is that they have been triggered by bank failures as
they pop up and, as a result, have only dealt with the symptoms. The liquidity
crisis is pulling down asset prices in an indiscriminate way, thereby
transforming the liquidity crisis into solvency problems of individual banks.
The governments, then, are forced to step in and to recapitalise the bank only
to find out later that when the liquidity crisis strikes again, the capital has
evaporated. The governments throw fresh capital into a black hole, where it
disappears quickly.

Central bank liquidity provision, although necessary, has also failed to address
the co-ordination failure and has only made it easier for banks to dispose of
long assets to acquire short ones (cash). Thus central banks? liquidity
provisions do not stop the massive destruction of credit and liquidity that is
going on in the economy.

The recent decision of the US Federal Reserve to bypass the banking system and
to lend directly to the non-banking sector by buying commercial paper is a step
in the right direction. It allows companies to obtain cash by borrowing long; a
service banks do not want to provide anymore. The step taken by the Fed is
insufficient, however. The Fed cannot take over all bank lending operations.
Only the government can do this by temporarily transforming private banks into
public ones. It can then order the management of these state banks to lend to
each other.

Such a transformation (call it a temporary nationalisation) will make it
possible to jump start the interbank market and allow the normal flow of credit
to be activated. Nationalising the banking system is not the only intervention
necessary. There is today a general distrust of private debt. This will force
the government to substitute private debt for public debt. The Paulson plan
does just that. More Paulson plans will be necessary to put a floor on the
price of private debt and to prevent a meltdown.

The temporary nationalisation of the banking system and the substitution of
private debt by public debt will allow us to reach a new equilibrium. When this
happens, a fundamental reform of the banking system will be necessary in order
to remain in this benign equilibrium. When this is achieved the governments
will be able to privatise the banking system again.

The writer is professor of economics at the university of Leuven and Centre for
European Policy Studies



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