A Bank Bailout That Works

Editor's Note: An earlier version of this essay erroneously stated that Sen. Christopher Dodd supports bank nationalization. In fact, Dodd has said he does not welcome nationalization, but "we may end up having to do that."

The news that even Alan Greenspan and Senator Chris Dodd suggest that bank nationalization may be necessary shows how desperate the situation has become. It has been obvious for some time that a government takeover of our banking system--perhaps along the lines of what Norway and Sweden did in the '90s--is the only solution. It should be done, and done quickly, before even more bailout money is wasted.

The problem with America's banks is not just one of liquidity. Years of reckless behavior, including bad lending and gambling with derivatives, have left them, in effect, bankrupt. If our government were playing by the rules--which require shutting down banks with inadequate capital--many, if not most, banks would go out of business. But because faulty accounting practices don't force banks to mark down all their assets to current market prices, they may nominally meet capital requirements--at least for a while.

No one knows for sure how big the hole is; some estimates put the number at $2 trillion or $3 trillion, or more. So the question is, Who is going to bear the losses? Wall Street would like nothing better than a steady drip of taxpayer money. But the experience in other countries suggests that when financial markets run the show, the costs can be enormous. Countries like Argentina, Chile and Indonesia spent 40 percent or more of their GDP to bail out their banks. For the United States, the worry is that the $700 billion appropriated for the bank bailout may turn out to be just a small down payment.

The cost to the government is especially important, given the legacy of debt from the Bush administration, which saw the national debt soar from $5.7 trillion to more than $10 trillion. Unless care is taken, government spending on the bailout will crowd out other vital government programs, from Social Security to future investments in technology.

There is a basic principle in environmental economics called "the polluter pays": polluters must pay for the cost of cleaning up their pollution. American banks have polluted the global economy with toxic waste; it is a matter of equity and efficiency that they must be forced, now or later, to pay the price of cleaning it up. As long as the banking sector feels that it will be bailed out of disasters--even ones it created--we will continue to have a moral hazard. Only by making sure that the sector pays the costs of its actions will efficiency be restored.

The full costs of those mistakes include not just the $700 billion bailout but the almost $3 trillion shortfall between the economy's potential output and its actual output resulting from the crisis. Since we are not forcing banks to pay these full costs imposed on society, we should hear no complaints from them about paying for the much smaller direct costs of the bailout.

The politicians responsible for the bailout keep saying, "We had no choice. We had a gun pointed at our heads. Without the bailout, things would have been even worse." This may or may not be true, but in any case the argument misses a critical distinction between saving the banks and saving the bankers and shareholders. We could have saved the banks but let the bankers and shareholders go. The more we leave in the pockets of the shareholders and the bankers, the more that has to come out of the taxpayers' pockets.

Principles and Goals

There are a few basic principles that should guide our bank bailout. The plan needs to be transparent, cost the taxpayer as little as possible and focus on getting the banks to start lending again to sectors that create jobs. It goes without saying that any solution should make it less likely, not more likely, that we will have problems in the future.

By these standards, the TARP bailout has so far been a dismal failure. Unbelievably expensive, it has failed to rekindle lending. Former Treasury Secretary Henry Paulson gave the banks a big handout; what taxpayers got in return was worth less than two-thirds of what we gave the big banks--and the value of what we got has dropped precipitously since.

Since TARP facilitated the consolidation of banks, the problem of "too big to fail" has become worse, and therefore the excessive risk-taking that it engenders has grown worse. The banks carried on paying out dividends and bonuses and didn't even pretend to resume lending. "Make more loans?" John Hope III, chair of Whitney National Bank in New Orleans, said to a room full of Wall Street analysts in November. The taxpayers put out $350 billion and didn't even get the right to find out what the money was being spent on, let alone have a say in what the banks did with it.

TARP's failure comes as no surprise: incentives matter. Bankers won't restart lending unless they have a reason to do so or are forced. Receiving billions of dollars in bonus pay for racking up record losses is a peculiar "incentive" structure. Bankers have been accused of unbounded greed using hard-earned taxpayer dollars for bonuses and dividends, but economists more calmly observe: they were simply responding rationally to the incentives and constraints they faced.

Even if the banks had not poured out the money in bonuses as we were pouring it in, they might not have restarted lending; they might have just hoarded it. Recapitalization enables them to lend. But there is a difference between the ability to lend and the willingness to lend. With the economy plunging into deep recession, the risks of lending are enormous. TARP did nothing to require or create incentives for new lending, focusing instead on cleaning up past mistakes. We need to be forward-looking, reducing the risk of new lending. Just think of what new lending $700 billion could have financed. Leveraged on a modest ten-to-one basis, it could have supported $7 trillion of new lending--more than enough to meet business's requirements.

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