Today I was reading Felix…

[F]or many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream — one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late 70s and early 80s, the S&P 500’s dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price.

And then Mish…

How many billions of dollars did GE [whose stock currently trades for about $18] waste buying shares back over the years at $40 or greater? $35 or greater? $25 or greater? $20 or greater? Think of where GE might be if it used the money to pay down debts rather than buy shares at absurd prices.

I see that GE is paying a dividend of 6.6% while borrowing money from taxpayers to fund operations. How long can that dividend last?

If you take an introductory finance class, you will learn that firms can return cash to their shareholders in two ways. They can issue dividends, or they can use the same money to buy-up shares from shareholders. Fundamentally, you will learn, these two approaches are equivalent: With a dividend, all investors receive some cash, but the stock they hold loses value. In a buyback some investors sell shares and receive cash, leaving investors who hold their stock with a less “diluted” claim on the assets of the firm, making the payout equitable to all shareholders.

To clarify, suppose there is a firm whose sole asset is $1,000,000 in cash and two shareholders. The firm could pay a dividend of $500,000, giving $250,000 in cash to each shareholder. Alternatively, the firm could buy out one of the shareholders, paying $500,000. In the first case, both shareholders end up with $250,000K worth of stock and $250,000 in cash. In the second case, one shareholders ends up holding $500K in cash while the other shareholder holds stock worth $500K. In financial terms, everyone gets a fair deal either way.

However, conventional wisdom has it that share buy-backs offer important advantages that may make them superior to dividends payments:

• Preferential tax treatment — Investors are more lightly taxed with buybacks, especially if dividends are taxed more heavily than capital gains. With buybacks, those who sell are taxed only on net gains (a smaller amount than the cash actually received, and perhaps at a lower capital gains rate), while those who don’t sell are not taxed at all until they sell sometime in the indefinite future.

• Flexible reinvestment with low tax and transaction costs — With a dividend, people who want to stay invested in a firm have to accept and pay taxes on the dividend, and then incur transaction costs to reinvest the proceeds back in the firm. With a buy-out, investors who want to stay invested very efficiently do nothing, while those who want cash can sell into the buyback.

• Cash-management flexibility for the firm — For whatever reason, firms are expected to keep dividend payments stable and increasing over time, even though business profits and cash needs may be very volatile. Firms that cut regular dividends are often punished by the market. Discretionary stock buyback programs allow firms to return cash to shareholders when business conditions permit and withhold payouts as cash needs grow while maintaining a smooth and stable dividend policy.

All of this would be well and good in a world with perfectly efficient markets, no asymmetric information, and investors whose portfolio preferences are continuously enforced.

But consider an uncertain world in which firms are frequently mispriced, and where many investors have limited attention and rebalance their portfolios only infrequently. (Among this latter group would be buy-and-hold investors who hold a fixed portfolio and either consume the dividends or reinvest them pro rata in a broad portfolio rather than in the issuing firm directly.) In this more realistic world, share repurchases benefit informed and flexible investors at the expense of their less informed or more rigid partners, while dividend payments reduce the ability of informed investors to profit at the expense of other investors.

Let’s first consider the case where some investors know a firm’s stock to be overpriced. Informed investors are more likely to sell into overpriced buyouts, extracting cash from firms at the inflated share price while concentrating the burden of future write-downs on long-term, less-informed investors. A dividend, on the other hand, would return cash equitably to all investors, automatically disinvesting slower investors from the overpriced stock, and forcing informed investors to share in losses. Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm’s poor prospects, and cause the share price to fall before they can exit. (That’s how information is supposed to get impounded into markets prices!) With or without the buyback program, investors in an overpriced firm must suffer the cost of a downgrade, but the cash disbursal policy affects the distribution of the losses. Returning cash via buybacks lets the informed shift losses to the uninformed, while the same cash distribution via dividends reduces the eventual cost to slow investors and forces informed investors to share more of the pain.

With an underpriced firm, the difference is less stark. Only ill-informed or liquidity constrained investors sell their shares into a buyback, concentrating future gains in the hands of both informed investors and slow buy-and-hold investors. So although informed investors do gain, the gains are more broadly shared: “slow money” as well as “smart money” benefits, the losers are ill-informed investors or random people who need cash. When an underpriced firm issues dividends, all investors are partially disinvested from a firm whose shares are destined to appreciate. But active, informed investors are likely to reinvest, potentially informing the market and provoking a revaluation towards fair value that benefits all investors. If the market adjusts quickly to the reinvestment flow, informed investors may not be able repurchase very much stock at all from less informed investors before the price adjusts, leaving the revaluation gains broadly shared among all investors rather than captured mostly by the informed.

An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don’t repurchase stock than if they invest in firms that don’t pay substantial dividends but use stock buybacks to “return cash”.

This line of thinking opens up interesting questions about for whom a firm is to be managed. The party line is that firms should be managed for the benefit of shareholders. Even if that is true, for which shareholders should it be managed? One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors, and create incentives for management to buyback overpriced shares even though in some sense this is bad for “the firm”. (There are lots of anecdotes about hedge funds and other activist investors lobbying successfully for share repurchases by firms that turned out to be overpriced.)

Even if one imposes a fiduciary obligation on management to treat all shareholders equally, it’s not clear that management is betraying its trust by working to inflate share prices and creating opportunities for the savvy to cash out. Even if the strategy harms future earning streams, it creates a valuable option that is ex ante available to all shareholders, and the option value of a firm is a real and often substantial component of its worth. If markets are not efficient, it’s quite possible that maximizing current shareholder value is inconsistent with maximizing discounted infinite horizon profit streams, which leads one to question whether current shareholder value is a very useful metric of firm value from a social welfare perspective.

A few weeks ago, Dani Rodrik issued a challenge:

[A]dvocates [of financial innovation] owe us a bit more detail about the demonstrable benefits of financial innovation. What I would love to hear are some examples such financial innovation—not of any kind, but of the kind that has left a large enough footprint over some kind of economic outcomes we really care about. What are some of the ways in which financial innovation has made our lives measurably and unambiguously better?

If I had asked this question a little over a year ago, I suppose I would have been hearing a lot about how collateralized debt obligations and structured finance have allowed millions of people to purchase homes that they would not have been able to afford otherwise. Sorry, but you will have to come up with some other examples now.

I will give Dr. Rodrik some of what he wants, that is, examples. But first, I have a nit to pick. In citing last year’s would-have-beens, Rodrik has offered up the textbook marker of an anti-innovation.

…have allowed millions of people to purchase homes that they would not have been able to afford otherwise.

Any claim that a financial innovation has achieved a concrete, positive end is a sure sign of disaster, or (in the unfortunate lingo of economics) a distortion. The purpose of a financial system is to solve a collective optimization problem whose solution we cannot guess a priori. If we are very sure that welfare is maximized by vastly expanding the housing stock and making homeowners of people who otherwise might not buy, then the government should just tax to build McMansions, and auction off the oversupply. More generally, one cannot judge a financial system by any particular outcome, because all financial systems make mistakes, and the mistakes always look good while they last. We judge financial systems by the performance of the economies they guide over time.

Rodrik has asked for examples of good innovations. Here are a few on my list:

• Exchange-traded funds
• The growth of venture capital and angel investing
• The democratization of access to financial information (e.g. Yahoo! finance)
• The democratization of participation in financial markets (e.g. the growth of internet and discount brokerages that offer easy access to a wide variety of stocks, bonds, and exchange-traded derivatives, both domestic and international).

No list of good innovations is complete without a list of bad innovations. Obviously at the top of the list go CDOs, CPDOs, OTC credit-default swaps, the general alphabet soup of the structured finance revolution. (I would not, however, put all mortgage or asset-backed securities on the list. Well-constructed asset-backed securities, those that are transparent and not overdiversified, are very much like ETFs, and if they were more widely accessible I’d place them directly in the “good” column.) But there are many, many more bad innovations that we have yet to come to terms with:

• 401-K plans with limited investment menus
• The conventional wisdom that long-term savings ought by default be placed in passive stock funds
• The conflation of ordinary saving and financial return seeking
• The tolerance, advocacy, and subsidy of financial leverage throughout the economy
• The move towards large-scale, delegated, and professionalized of money management
• The growth of investment vehicles accessible primarily or solely to professional and institutional investors

How do I distinguish the good innovations from the bad? I cannot do what Dani Rodrik asks, and point to concrete good outcomes, and I have no studies to show that economies with tools I prefer outperform those without. In engineering fields, one develops and chooses innovations not by virtue of historical experience, but by application of a theoretical toolkit that prescribes what would work if it were tried. Of course, eventually historical experience either vindicates or discredits the theory, but I have a theoretical view, and I claim that it has not been discredited. Here are a few principles:

1. Financial systems are means of aggregating diverse, decentralized information into patterns of capital creation in the real world. Financial innovation ought to be judged by how capably they facilitate this information transmission. By this criteria, “opaque” financial instruments — these include everything from complex tranches of CDOs to certificates of deposit at your local bank — are presumptively bad. If an investor does not know and actively choose to bear the risk of the real projects she is investing in, then she is introducing noise into the allocation decision. On a sufficiently large-scale, this noise will lead to allocative errors and widespread catastrophe with probability one.

   Good innovations:

   • Are transparent, investors can understand what they are investing in.
   • Are expressive, that is they increase the range of widely dispersed information that investors can impound into an investment decision.
   • Are compartmentalized, the parties upon whom the costs and benefits of the investment decision fall are well-defined, and these parties accept and are capable of bearing the risks they have chosen without external support.

2. Savers should not be investors, that is they should not be underwriting the execution of projects about which they have no opinion and whose risks they are unwilling to bear. Savers’ sole legitimate goal is to transmit their current wealth into the future with the minimum loss possible. (Savers who want to earn a real return must become investors, that is they must perform informational work and bear risk.) Our current system does not serve savers well, because our markets offer inadequate ways of purchasing claims on future consumption (as opposed to claims on future production). This is a tragedy both for savers (baby-boomers who are losing their retirements ought to have been able to “buy forward” their housing, food, transportation, etc. years ago), and for the economy as a whole, because information about future consumption is lost, and we have no reason to believe that the salesmen who pawn off “savings products” are qualified to make outsized contributions to the allocation decision.

3. A primary goal of a financial system is to allocate and minimize the burden of economic risk. That has two implications:

   • To the maximum degree possible, the financial system ought not introduce risks that are not inherent to the real projects it is underwriting. In particular, financial systems should be designed to minimize what I’ll call “secondary counterparty risk” — the risk that an intermediary will fail to pay a claim that is not made explicitly contingent by the terms of the investment contract. Secondary counterparty risk is tacit, it is opaque (since human enterprises are never perfectly transparent and inter-relationships are complicated, we can never know a counterparty’s capacity to pay), and the informational problem of evaluating and quantifying it grows exponentially with the size and complexity of financial intermediation. So, financial intermediation ought be kept as “thin” and simple as possible. Having vast numbers of intermediaries bound into unstructured and unknowable networks by virtue of idiosyncratic bilateral claims is obviously dumb.

   • The risks inherent to real economic projects, which include ordinary investment risk and “primary” counterparty risk (you lend to an enterprise that fails, as opposed to the failure of a financial intermediary), should be very clearly allocated, and financial markets should not make it easy for risk-bearers to escape the consequences of their risks by ex post transfers in overly “liquid” markets. As much as possible, investors should be able to choose the level of risk they bear, and should plan to reap the fruit or accept the costs those choices in a very straightforward manner.

Some miscellaneous comments:

• Complexity is much more often a marker of snake-oil than of quality in a financial instrument. “Sophisticated” investors are almost always predators or fools. The real-world informational problems investors face — what is it that should be done? how ought our resources be deployed? — are challenging enough. Creating structures that cannot be understood except by applying complex models that may or may not adequately capture the behavior of the instrument is just idiocy, a mish-mash of quant hubris and pseudoscientific salesmanship.

• There is no inherent tension between financial innovation and regulation in designing a financial system. Some regulation compels and encourages useful innovation. For example, if as an outcome of the current crisis, banks find their leverage tightly constrained, it may be necessary for a new ecosystem of investment funds to arise to meet the needs of investors who otherwise would have lent to banks and enterprises that previously relied on bank financing. That is, a “local venture capital” boom might arise as a direct consequence of bank regulation. Further, much good regulation is itself a form of financial innovation. Centrally-cleared, collateralized derivatives exchanges are incredibly clever devices, whose function and regulation are intimately intertwined. Good regulation does not take the form of minions of the state saying “no! non! nyet!” to hearty capitalists. Good regulation involves the clever definition of market structures to which participants are naturally drawn because they function well. Regulation itself can be a form of financial innovation, as in “cap-and-trade” pollution control schemes, Warren Buffet’s import-certificate proposal, or congestion-pricing of trades in financial markets.

So, this has been a sprawling brain-dump, rather than a clear-headed vindication of the proposition “financial innovation can be good”. Despite the deficiencies of the essay, I strongly believe that transitioning from our current, very broken, financial system to something better will require a great deal of innovation, along with regulation. We should think of the financial system as an integrated system, and work creatively to improve both its private-sector and public-sector components. We should be humble, and careful, and introduce big changes incrementally where possible. We should try to bear in mind the social purpose of a financial system, and use that as a yardstick against which to evaluate new ideas. But we must make big changes, and it will not be enough to tell people what they cannot do. We want a financial system that is safe and simple, but also expressive and dynamic and capable of taking large, well-considered risks. We will have to invent to get what we want. The stakes could not be higher.

OK. So, stock markets are, like, tanking.

But the new conventional wisdom has it that stock markets aren’t really where the action is. To gauge how the crisis is unfolding, we are told, we should pay attention to credit indicators, particularly indicators that compare the cost of interbank lending to the cost of “risk-free” government borrowing, such as the TED spread.

Felix Salmon has done a nice job of pointing out the flaw in these indicators: Banks don’t actually have to borrow at the elevated interbank rates, as long as central banks are willing to lend directly at much lower rates. So, it’s unclear whether interbank borrowing rates like LIBOR are meaningful as measures of interbank counterparty risk. As Felix notes:

Libor is an indicative rate: it’s the rate at which banks would lend to each other, if they were lending. If they stop lending, they still need to report some interest rate to the Libor committee. But it might well bear very little relation to banks’ cost of funds in the real world, where the interbank markets are becoming increasingly dried-up and unhelpful.

What is very clear is that LIBOR serves as the basis of many thousands of private sector contracts, and that the banking system as a whole is a net receiver of LIBOR-indexed funds. To the degree that LIBOR does not reflect banks effective cost of funds, an elevated rate can be viewed as a hidden tax of the nonfinacial sector by banks. Rather than reflecting the banking system’s pain, a high LIBOR might indicate banks’ ability to leverage their collective insolvency to charge higher rates on nonfinacial firms without complaint.

The oddest duck in the credit indicator menagerie is the LIBOR-OIS spread. That’s a measure of the difference between what banks claim they have to pay to borrow from one another and what the market actually expects they would pay, if they adopted a strategy of borrowing overnight from, err, one another in the Federal Funds market. Both legs of the LIBOR-OIS spread represent unsecured interbank lending, so it’s not obvious how this measure captures counterparty risk. It does, to a degree, because counterparties of a bank rolling overnight loans can choose not to renew the credit, should bad news strike, while a bank that extended a term loan at 1-month or 3-month LIBOR can do nothing but watch the fall. In a sense, LIBOR-OIS can be viewed as the price of an option to call a loan, to the degree that LIBOR accurately reflects the cost of interbank term financing.

But since US banks can borrow from the Fed’s discount window at the Federal Funds rate + 25 basis points, while adjustable rate loans from banks are often indexed to LIBOR, a simpler way to think of the LIBOR-OIS spread is as a measure of the difference between the cost to banks of central bank money and rate they charge on private loans. Put this way, it is hard to understand why banks are upset that this indicator is elevated.

If this seems overly cynical, it’s worth considering what happened to a LIBOR predecessor, the Prime Rate during the last US banking crisis.

Why did Ben Bernanke, widely respected among economists as both a scholar and gentleman, support a rescue plan that very few of his colleagues considered “first-best” or even “second-best”? While there was no firm consensus among economists about precisely what ought to have been done, a plan based on no-strings-attached purchases of difficult-to-value assets by taxpayers was particularly surprising. Here’s Greg Mankiw being politely puzzled. Paul Davidson quotes correspondence with Chris Carroll, in which the Hopkins economist admits he wants to

spur Bernanke to try to provide his own views… My suspicion …is that he [Bernanke] thinks buying the toxic assets is a bad idea …. I think Bernanke believed all along that a recapitalization was the only effective thing that could be done, but he could not persuade Paulson of that.

Cynics can easily find reasons for Secretary Paulson to have favored the original TARP proposal. But why did Dr. Bernanke play along?

Here’s a possibility: Sometime in the middle of September, the Fed hit its balance sheet constraint. Dr. Bernanke could not have provided liquidity on the scale he thought necessary to support the financial system without injecting unsterilized new cash into the banking system and potentially sparking inflation or a run on the dollar. At that moment, the U.S. Federal Reserve lost its independence entirely. In order to pursue the policy its technocrats thought best, it required large-scale funding from the US Treasury. Dr. Bernanke had to negotiate with Secretary Paulson, whose nickname “The Hammer” is not a tribute to his love of carpentry. A deal was struck, and the Supplementary Financing Program was born.

Undoubtedly, inside both the Fed and the Treasury, a variety of options were considered on how to intervene as credit conditions continued to deteriorate. Perhaps the Treasury settled upon the TARP approach, while the Fed might have preferred something different. Perhaps the Fed had to give a little to get a little. Perhaps that’s why the Paulson Plan emerged as what Greg Mankiw terms the “new Washington consensus”.

The Fed has now regained some of its independence. The “stabilization act” included a clause that gives the Fed authority to pay interest on bank deposits, which permits the central bank to partially sterilize cash injections without having to sell securities from its much depleted portfolio.

But in mid-September, events were spiraling, and the Fed was cornered. Even a gentleman and a scholar might have decided that acceding to a proposal that could do little immediate harm and might do some good was better than having his hands tied and watching the banking collapse he was born to prevent unfold before his tired eyes.

So, you don’t want to nationalize all the bad banks, and neither does Megan McCardle. After all, America is not Sweden, we’re heterogeneous and fractious and really gosh-darn big. American politics are nasty, brutish, and interminable — no way to run a lemonade stand let alone a bank. Okay.

Unfortunately, the private sector approach to reorganizing and recapitalizing banks, forced debt-to-equity conversions, is too harsh on creditors. Yes, it is the free-market solution, and it’s what we normally do (via the bankruptcy process) when firms are viable but undercapitalized. But, we are afraid of hurting lenders at a moment where credit markets are wobbly and a strike by lenders could be catastrophic. Okay.

Maybe these are two great tastes that taste great together. What if both the state and junior creditors could took equity stakes in reorganized firms, fifty-fifty. The former creditors would run the place without government interference, isolating management from politics and diminishing concerns of creeping socialism. Taxpayers would enjoy the upside as passive investors in ordinary, profit-maximizing businesses, and would buy shares at a bargain price (book value after very aggressive write-downs have been taken). Some creditors would still have to endure the indignity of being converted to equity, but the amount of debt that would have to convert would be cut in half (approximately), giving converted debtors a lot of capitalization bang for their buck. Junior creditors would go from owning very dodgy debt to relatively safe shares, and more senior creditors would see the value of their positions spike and stabilize as solvency concerns abate.

Here’s how this would work:

1. Regulators would go over bank balance sheets, and come up with a very conservative account of their assets. Nothing would be carried at more than market, in-quantity bids. That’s a fire sale price? Too bad. There’s no market bid at all? That’s a zero then.

2. Any bank that is undercapitalized on this basis, that is beneath the regulatory thresholds for an adequately capitalized bank, is insolvent. Equityholders, common and preferred, are wiped out. Sorry, Charlie. You levered up, you bought crap, you lost. That’s how it goes. I love the smell of capitalism in the morning.

3. We choose a “well capitalized” leverage ratio, and that will tell us how much debt we’ll need to convert to equity. Here are the formulas, if I’ve got my algebra right:

   government_equity = converted_equity =
      (total_assets / (2 * target_leverage - 1))
   reqired_conversion = converted_equity - old_book_equity

   …where old_book_equity is the book value (a negative number) of the now wiped old equity.

4. We define two classes of stock, one voting and one nonvoting but convertible to the voting shares, each with a par value of $1. The government puchases its share, by purchasing government_equity shares of the nonvoting stock at par. The government is forbidden from exercising the conversion option.

   The required amount of debt is converted to converted_equity shares of voting stock, which is distributed to creditors pro rata based on the amount of equity converted. (Equivalently, a conversion rate of required_conversion / converted_equity is established.)

5. The firm would have the option of paying unsecured contingent liabilities that arise from contracts entered into prior to the reorganization in stock at the conversion rate established for other creditors. This has the effect of placing undercollateralized derivative counterparties where they belong, in the same boat as the most junior creditors of the firm. It’s also good from a “moral hazard” perspective — we really, really want people to take counterparty risk seriously in whatever OTC derivaties market survives this episode, but we don’t want to wipe out existing counterparties and set-off a cascade or meltdown. Counterparties to reorganized firms would take a haircut, and salutary uncertainty would be introduced in valuation schemes that too often begin by assuming away counterparty risk.

6. If a firm is so profoundly insolvent that, even with the government capital infusion, the required debt-to-equity conversions would have to hit depositors (at banks) or claims on assets held on behalf of clients (e.g. stocks held for clients by brokerages), then the firms should be liquidated, with the government honoring FDIC and SIPC guarantees. If any such firms are systemically important, they’d have to be nationalized outright, like AIG. Half-measures can’t save such firms. (Thanks to Winterspeak for pointing out this issue.)

The aggressiveness of the writedowns in Step 1 is the core protection for taxpayers in this plan. If that’s watered down, this could become a taxpayer subsidy to converted creditors. Also, to protect taxpayers, creditors should never be able to purchase shares more cheaply than the government. Under the formulas above, that would happen when the book equity of the reorganized firm is positive, but less than regulatory capitalization thresholds. In this case, the new owners effectively get a subsidy, a wealth transfer from old equityholders, during the reorganization. This subsidy should be shared by converted creditors and the government. The formulas above allocate old book equity to converted creditors, to ensure that creditors rather than taxpayers bear prereorganization losses, and would have to be modified when old book equity is positive:

government_cash_infusion =
   (total_assets - (old_equity * target_leverage)) /
   (2 * target_leverage - 1)
government_equity = converted_equity =
   (total_assets + government_cash_infusion) /
   (target_leverage * 2)
reqired_conversion = converted_equity - (0.5) * old_book_equity

…and the government would buy shares at the same conversion rate paid by creditors, rather than at par.

I’ve written about the Federal Reserve a good deal, and I’ve been critical of its willingness to take private sector risk onto its balance sheet by swapping Treasuries for the increasingly dodgy securities produced during the credit bubble.

The (hopefully defunct) Paulson Plan has provided a come to Jesus moment. Having the Fed lend money against overpriced collateral valuations is infinitely superior having the Treasury purchase those securities outright at inflated prices. While the taxpayer is on the hook in either case, at least when the Fed lends, the taxpayer loses only if the borrower first fails. If the Treasury Secretary overpays for an asset, the original owner books the profit and the taxpayer eats the loss directly. A “quiet bailout” from Dr. Bernanke strikes me as much more equitable than a sellers’ market fashioned by Secretary Paulson.

Lending from the Fed even against worthless collateral cannot address undercapitalization of the banking sector. Neither could the Paulson Plan, unless the Secretary were to overpay for bank assets. Removing the ability and incentive to overpay on a permanent sale strikes me as a good thing. Recapitalizing the banking system will require more than easy money from the Fed. But easy money, combined with a bit of temporary forbearance on capital requirements, would help blunt the current panic, while leaving bank stockholders and creditors on the hook before any losses would be taken by taxpayers.

The big hazard of this approach is as it has always been, how to wean the banking system from the mother’s milk of Fed largesse. Many banks are insolvent, and those banks need to be identified, reorganized and recapitalized (or else liquidated). That should happen quickly — not zombie style over the course of a decade — but it needn’t happen instantaneously and simultaneously. In order to even get started, we need to have a fair endgame, a good approach to reorganizing and recapitalizing banks. I’m already on record as supporting either temporary nationalization (a la the Scandinavian model or AIG), or internal recapitalizations via debt to equity conversions. It’s possible that a combination of these two approaches, one that doesn’t give government direct control over reorganized banks and includes both internal and public sector capital injections, might be more palatable than either choice alone. That will be the subject of my next post.

In the meantime, I would support a standalone act authorizing the Fed to pay interest on deposits immediately. I would prefer that Congress impose limits on the quantity of deposits on which interest can be paid, to limit the risk and interests cost to taxpayers, but that limit could be quite loose for the moment. This approach has the advantage of getting liquidity into the banking system far more quickly than the Paulson Plan ever could have, and drawing a clear line between the liquidity and capitalization aspects of the plan. It could be implemented immediately by passing the one sentence Section 128 of the Paulson Plan in isolation (although again, I’d prefer to muck it up with a limit on the quantity of paid deposits).

Freed of its balance sheet constraint, the Fed might consider injecting funds into the banking system by purchasing a diversified portfolio of holdings in money market funds that trade in commercial rather than government paper. This would help relieve the stresses in the commercial paper market very directly, and reduce the likelihood of a disorderly adjustment in nonfinancial commercial credit markets.

I remain adamantly opposed to the “Emergency Economic Stabilization Act of 2008”. And I’m astonished that so many who opposed the bare-bones Paulson Plan have, however begrudgingly, risen to support this proposal. Yves Smith is right that “turning Hank Paulson’s three pager into a 110 page draft made for a nice fig leaf but made virtually no substantive difference.” There is a bit more accountability and transparency. But, there are also huge new powers for the Federal Reserve and the SEC that weren’t in the original, and were inserted with no public debate. All the rest, the equity sharing, the “installment plan”, the compensation limitations are weak, and the act specifically authorizes the Treasury to overpay for assets (that is, “at the lowest price that the Secretary determines to be consistent with the purposes of this Act”).

There has been so much talk of catastrophic consequences if we do not support this bail-out. What happens if we do pass the act — over the clear objections of the vast majority of Americans — and the depression still comes?

I think people are severely underestimating the depths of the crisis we are in. This is not a financial crisis about banks and commercial paper. It is not about the housing market. We are in an economic crisis, because America’s productive capacity is deeply out of kilter with our habits of consumption. No amount of financial legerdemain can fix that. We have to actually produce the goods and services we want to consume, or else produce current goods and services that we can trade for what we consume. Relying on the mysteries of finance to square the circle has brought us low. At best, the proposed bail-out might buy us some time to fix the underlying economics before the pain kicks in. At worst, the pain will kick in anyway, but we’ll have even less flexibility than we have now to address the real problems.

Suppose we pass the “Emergency Economic Stabilization Act of 2008”, and a depression comes anyway, and we cannot raise taxes (blood, turnips, all of that), and we cannot borrow from abroad (because our paymasters have tired of us). Sure, the Federal Reserve will print money, because the debt must be paid and the government must continue, and in a depression many prices will fall regardless, but commodities and imports will grow dear. We will know then that we want to build factories, for all the televisions and computers that used to be cheap from Asia, but that can no longer be bought with debauched greenbacks. But we won’t have the capital.

What will we say, in those dark days, when someone comes along and blames the bankers? It was the bankers, after all, who “intermediated” our vast current account deficit, who found ways of accepting goods and producing debt despite our incapacity to repay, and who enriched themselves by doing so. And then these self-same bankers threatened us with armageddon unless we paid them hundreds of billions of dollars, back when dollars could still buy steel and cement and machinery. We paid the ransom, but the hostage died anyway. How will Secretary Paulson answer their charge?

Suddenly we will realize the cost of putting expedience before even the thinnest veneer of justice. Because in the end, Secretary Paulson will answer these charges with a locked gate and an exception to the Posse Comitatus Act. An economic depression will bring temptations to violence and radicalism. And a lot of people will look back on this decade, right up to and through the “Emergency Economic Stabilization Act of 2008”, and feel with some justice that they were royally screwed.

Now, in a deep downturn, scapegoats will be found no matter what. Maybe we really have nothing to lose by passing this badly flawed proposal, since it might prevent a depression and if not we’re all toast anyway. But, you know what? While we still can borrow valuable dollars, we could use that 700B to build infrastructure that might make the economic facts of a depression less severe. And, if we insisted that the mighty bankers actually fall now, actually take the hit that their own ideology demands of them, that just might blunt the sense that we are “us” and “them”, rather than a nation with a common struggle, when it all hits the fan. Maybe the choice we are really making here is not about financial and monetary arcana, but a choice between civic peace and civil war.

Obviously this is speculative, and alarmist, while the crises in the credit markets are acute, real, and tangible. But we really could nationalize failing banks before they take down the credit markets, while bailing out senior creditors. It has been done. The Federal Reserve or the Treasury could buy high quality commercial paper if the money markets go on strike. (That’s much less risky than buying frozen mortgage assets.) We really could invest in productive infrastructure, rather than in claims on already built subdivisions. We do have other choices, besides starting the depression tomorrow or giving Secretary Paulson what he wants.

The Paulson Plan is now the easy out. It has a lot of momentum behind it. It feels safe. But it is not guaranteed to work even in the short run, and does not address the substance of our economic problems at all. Much of the public perceives the plan as at best a kind of ransom and at worst a kind of theft. The plan might buy us enough time to put our economic house in order, in which case it would have been well worth the cost. But if it doesn’t work out that way, if the public is forced to swallow a bail-out that seems flamboyantly unjust and everything falls to pieces anyway, we will have painted ourselves into a very dark corner. In a genuine catastrophe, social cohesion matters more than anything. Surely, by now, we should have learned not to underestimate tail risk.

So, I’m not a lawyer, I’ve gone through this very, very quickly, and I’ve got to run.

On the whole, I think this is basically last weekend’s Paulson Plan with much better oversight, more transparency, and a lot more words. Also, the Federal Reserve is given authority to pay interest on deposits, and thereby implement a “channel” or even a “floor” system of monetary policy (ht commenter RueTheDay). And, the SEC can suspend mark-to-market accounting requirments. Those are big things to slip in under the radar.

Some easy changes that would make me feel a little better:

• Section 114 on transparency: “assets acquired” should be changes to “assets acquired, obligations assumed, or any other use of financial instruments undertaken”, so that the Treasury’s participation in derivative markets or its assumption of contingent liabilities is made public.

• While disclosures are required for taking positions in financial instruments other than security purchases in Section 3(9)(b), there should be stronger controls, and those controls should apply regardless of whether the contracts entered into are mortage-related or not.

• The streamlined contracting described in Sec 107(a) should be toughened. Disclosures should be public, and approval by, not merely notification to, some oversight body should be required. The Bush Administration has a poor record on “streamlined contracting”.

• In general, a required disclosures and reports to committees under TARP should be required to be public.

Some miscellaneous bullets:

• The House Republican’s insurance plan has been added, presumably to salve egos, but that only harms the taxpayer.

• The equity participation portion is toothless, much less specific or meaningful than in the earlier Dodd proposal. If equity participation is your core criterion, it’s unclear to me how one could say “no deal” to last week’s plan but “deal” to this one. Yes, some kind of equity participation is broadly mandatory, but aside from general principles, the scale of that participation is wholly at the discretion of the Treasury Secretary.

• The compensation limitation section is very complex. Tin-foil-hat me thinks that this means there are loopholes by which the Treasury could structure participation in ways that prevent these requirements from biting, but going through the different sections, I wasn’t certain that I’d hit upon the scheme. There’s a fairly broad section that would create tax penalties for those who participate via auctions, and a much less specific section regarding beneficiaries of direct purchases. Tin-foil hat me thinks that those the Treasury Secretary wants to exempt will participate via direct purchases, and these players will be subject to vague, discretionary restrictions, or will be exempt due to a lack of meaningful equity participation. But overall, this section is too complicated for me to quickly make sense of.

My bottom line:

I still dislike this proposal and hope it does not pass. However, in a way, reading this makes me feel better about Secretary Paulson’s original plan. He was at least very honest about the powers he was asking for last weekend. Here he basically gets the same thing — although the added transparency and extra oversight is meaningful! — but all the verbiage blunts the impact.

Notes:

Below are, unedited and unexpurgated, the notes I took while reading the act. They are very quick and dirty, but I gotta run. My apologies in advance.

Sec. 3 (9) — Defines “troubled assets” to. Section (a) includes not only securities, but “obligations, or other instruments” related to mortgage assets, while Sec. (b) allows

any other financial instrument that the Secretary, after consultation with the Chairman of the Board of Governors of the Federal Reserve System, determines the purchase of which is necessary to promote financial market stability, but only upon transmittal of such determination, in writing, to the appropriate committees of Congress

The word “obligations” in (a) means that Treasury is authorized to assume the liabilities of private parties. The phrase “any other financial instrument” in (b) is very broad, and could include entering into contracts that put taxpayers on the hook for far more than any upfront cost. It’s clear that Congress recognized the danger associated with “any other financial instrument”, and insisted on some check. I would prefer this check be stronger, at least permitting “appropriate committees” to object, not merely be notified of a trade. In any case, the non-security “obligations, and other instruments” defined in Sec (a) need to be subject to the checks and oversight defined in Section (b). Assuming contingent liabilities can create a hole in the public balance sheet regardless of whether those liabilities are related to mortgages or other assets.

Sec. 101 (d) — Requires publication of

(1) Mechanisms for purchasing troubled assets.
(2) Methods for pricing and valuing troubled assets.
(3) Procedures for selecting asset managers.
(4) Criteria for identifying troubled assets for purchase.

Good.

Sec. 102 — Not only authorizes, but requires the Secretary to start a program to provide Federal insurance of troubled assets, if the core TARP program is implemented. I have a great deal of respect for the House Republicans for having slowed down this train, and still harbor some hope that they may stop it. But adding this insurance program is positively harmful. It increases the potential cost to taxpayers, if actuarially estimated premia turn out not to cover the cost of the claims. The "concession" the Republicans have insisted upon ended up creating a new potential hole in the taxpayer balance sheet. Two wrongs don't make a right, and two bad programs don't help the taxpayer. We'd be better off without this section. The insurance program creates a loophole by which taxpayer money can be given away, and th resulting losses blamed on good faith bad estimates. (Justin Fox points out that while the program is mandatory, the actual extension of guarantees is at the Treasury Secretary's discretion. I'm less confident that guarantees won't be offered than Justin is.)

Sec. 104 — The members of the newly defined "Financial Stability Oversight Board" are all members of the Executive Branch, with the exception of the Federal Reserve Chair, who is appointed by the President. WTF? There should be significant Congressional representation on this committee. The era of trusting the executive branch to do the right thing is long passed. Having only "reports and recommendations" sent to Congress is insufficient. It let's this committee set the options and determine the range of reasonable debate, just as Paulson and Bernanke did to us last weekend.

Also, it is insufficient that the reports and recommendations of the Oversight Board (which include financial statements, justification of prices paid, etc.) be sent to Congress. They should be made public.

Sec. 106 (d) — Requires that at least 20% of any profits be transferred to specific funds. That's dumb. These assets are being purchased from the General Fund of the Treasury. The General Fund of the Treasury should be made whole. If Congress wants to support the "Housing Trust Fund" or "Capital Magnet Fund" it should do that in separate legislation. Let's try to make the taxpayer whole, and then worry about make use of all our profits.

Sec. 107 (a) — Permits a "streamlined" contracting process under which ordinary checks on Federal contracting can be circumvented, if the justification for the circumvention is submitted to various committees. Given the plum jobs this act could create for financial intermediaries, and the degree to which precedents for extortionate compensation can be found in private sector contracts (2 and 20, anyone?), I am deeply uncomfortable with this. The Bush Administration has not won the public's trust with respect to no-bid contracting. "Streamlined" contracting should require more than notification, but active approval by some third party, and notification that contracts have been awarded through the streamlined process should be public, along with full details of the contracted arrangement.

Sec. 111 — This is the section containing the vaunted restrictions on executive pay. I cannot quicky understand or summarize it, as different rules apply for firms accepting direct purchases, participating in other ways, "golden parachutes", etc. I am suspicious that in all of this complexity there is room for the Treasury and firms to structure their participation in such a way as to evade the restrictions and penalties defined in the act. But I don't have the time or legal experience to think about all of the different what-ifs, and how this very complicated section of the act might apply.

Sec. 112 — Permits the Treasury to take "troubled assets" off the hands of foreign central banks, if the assets were issued by financial institutions that have defaulted. Whoa! What's this all about?

Sec. 113(2)(b) — The Treasury is specifically authorized not to purchase at the lowest price possible, but to purchase "at the lowest price that the Secretary determines to be consistent with the purposes of this Act". That's comforting.

Sec. 113(d) — While in general the Treasury has to acquire warrants or debt from participating firms, this section is much weaker than the "make whole" requirement reported in the Dodd proposal. The Secretary has complete discretion over the terms of these arrangements

(i) to provide for reasonable participa-
tion by the Secretary, for the benefit of
taxpayers, in equity appreciation in the
case of a warrant, or a reasonable interest
rate premium, in the case of a debt instru-
ment; and
(ii) to provide additional protection
for the taxpayer against losses from sale of
assets by the Secretary under this Act and
the administrative expenses of the TARP.

That's it. There are no teeth, nothing that says if a firm fobs an asset off and forces a serious loss on taxpayers, the Treasury will achieve a claim on the firm sufficient to make it whole.

Sec. 114 — Market Transparency. The good part:

To facilitate market transparency, the Secretary shall make available to the public, in electronic form, a description, amounts, and pricing of assets acquired under this Act, within 2 business days of purchase, trade, or other disposition.

The bad part: buying "assets" doesn't begin to cover all that TARP is permitted to do. What about the obligations or contingent liabilities it assumes? Those should be made public as well.

Sec. 115 — This is the part about the size of the TARP's balance sheet, including the celebrated "installment plan". It retains the huge loophole that restrictions apply to the size of TARP's balance sheet "outstanding at any one time". That is, Treasury could spend more money than these limitations seem to imply by purchasing and then reselling assets at a loss, then purchasing more. There are restrictions elsewhere, suggesting that Treasury must either hold-to-maturity or sell when it would be most advantageous to the taxpayer, but that leaves a whole lot of wiggle room. Treasury can always purchase, then claim to have revised its valuation and sell "advantageously" at a loss.

There's a lot of verbiage in this section about the procedure by which Congress could refuse the second $350B installment. The details are beyond my comprehension or interest, but broadly, by default Treasury gets the second installment unless it is specifically blocked by action of Congress.

Sec. 128 — Though there's no indication of what this is about in the plain language of the act, this is a stealthy acceleration of the Fed's ability to pay interest on deposits (ht commenter Rue The Day).

Sec. 131 — It looks like someone didn't like that the Treasury's guarantee of money market funds made use of the Exchange Stabilization Fund.

Sec. 132 — The SEC can suspend mark-to-market accounting requirements.

Sec. 134 — Recoupment... a ridiculous kick-the-can down the road, after 5 years we'll bill participants in the program for any loss. Right.

Sec. 310 — Looks like some kind of tax relief for losers on Freddie and Fannie preferred.

I really hate to disagree with Kevin Drum. He’s thoughtful, moderate, level-headed, smart. He’s the kind of guy who is, on balance, usually right. So, it makes me nervous to read his recent post, Pass the Effin Bill.

I don’t know if the financial universe will blow apart if Asian markets open tomorrow night and there is no bail-out in sight. I do know that the TED spread may not be telling us what we think it is, that the current proposal has almost nothing to do with the stressed out corporate paper market except via the catch-all term “confidence”, and that the timing of bank failures is largely at the discretion of the FDIC. I accept the principle that it is worth bearing significant costs to insure against even uncertain catastrophes, but other than cries of inchoate pain from anything labeled financial, I have yet to hear a compelling tale of why we should be confident that this expensive ounce of prevention will actually work. Hope is not a plan, and neither is discomfort.

Of course the people advocating the Paulson Plan have the capacity to create pain that might be perfectly avoidable. Yes that’s cynical. But that’s honestly where I am. Not only do I not have confidence in the solvency of the banking system, I don’t even have confidence that important players in both the public and private sectors wouldn’t use the tools at their disposal to create a little pain, until they bully the public into giving what they want. I know, I know, give me my tinfoil hat. But, if you believe the advocates of the Paulson Plan, major financial institutions would be insolvent if they marked their assets to current (um, “fire sale”) market bids. That’s not what their balance sheets say. If it’s true, investors and the public at large have been lied to for months by the leaders of the institutions to which we are expected to trust our life’s savings. And they want us to help cover that up. So, I’m cynical.

Anyway, for better or for worse, I was finally moved to do get political and write my representatives in Congress. I hope this was the right thing to do. For whatever it’s worth, here’s what I wrote:

September 27, 2008
To:	Representative Ben Chandler
Senator Jim Bunning
Senator Mitch McConnell
Re:	the “bail-out” (Fax transmission, 3 pages including this page.)

Like many voters, I feel helpless and angry as an astonishing bail-out of our corrupt and obsolete financial industry wends its way through the Congress. I am a new resident of Kentucky, have lived here for just over a year. The three of you are now my voice in Washington.

I am a doctoral student in finance at the University of Kentucky. I am not the world’s foremost expert in anything, but I am making the study of financial markets my vocation.

The legislation submitted by Secretary Paulson last weekend, if passed, would have been an astonishing arrogation of unchecked power. I fear for the United States of America that the proposal was even considered by the Congress, and described as “a good foundation” by Senator Schumer. After his crass attempt to assume near dictatorial power, I have lost my trust in Secretary Paulson. I believe this financial industry insider must be kept on a very tight leash for the few months he has left to help his friends and former colleagues on Wall Street.

I do, however, believe that we face a financial emergency, and that the Congress could play a constructive role in resolving the crisis in a manner that protects taxpayers and the general public and ensures that those responsible for our financial collapse bear most of the costs. I think there are two workable paths, one fully public and one fully private. I am open to both approaches. But I am adamantly opposed to a "public / private hybrid" solution, because frankly, I don’t think even our most well-intentioned public officials can avoid being milked and hoodwinked by the world’s greatest dealmakers. Either the Federal government should take over failing institutions, as it has taken over the insurance giant AIG, or the barrier between the public purse and the private banks should be made impermeable. The first thing that any legislative proposal should do is remove the gun that bankers currently hold to the head of our nation: the threat of disorderly bankruptcies. All systemically important financial firms should be subject to a controlled procedure in the event of insolvency, and should only have access to ordinary Chapter 11 reorganization or Chapter 7 liquidation after regulators have vouchsafed that such a filing would not imperil the nation’s financial system. Similarly, a petition by a creditor for involuntary bankruptcy should trigger the same regulatory review.

The Congress should choose either a private sector or public sector approach to managing the failure of systemically important firms. A private sector approach should follow the principles outlined by University of Chicago Professor Luigi Zingales. [See http://faculty.chicagogsb.edu/luigi.zingales/Why_Paulson_is_wrong.pdf] All of our financial firms are "asset rich" — they have plenty of money, it’s just that they have too much debt. They can be rendered liquid and solvent by requiring some creditors to accept equity in the firms in exchange for their debt claims. This is a perfectly fair outcome: People who lent these highly leveraged companies money knew or ought to have known they were taking a risk, and capitalism requires that lenders every bit as much as stockholders take responsibility for the soundness of the firms in which they invest. Unless these firms are quite profoundly insolvent, most creditors should take only a small haircut on the value of their debt, and could profit over time if the firms recover. Even the thorny issue of derivatives and other contingent liabilities can be addressed in this fashion: Firms that undergo a “fast-track reorganization” would be given the right to pay these obligations in the form of $1 par value preferred stock (the structure of which would have to be defined by Congress). Counterparties to derivatives transactions would undoubtedly prefer cold cash to company stock, but at least these contracts wouldn’t become fully worthless, as they would have under ordinary bankruptcy. Since counterparties would take only a haircut rather than a total loss, debt-to-equity conversions would help minimize the likelihood of cascading defaults on derivative contracts, the dreaded "CDS meltdown".

A public sector approach the problem would be to let the controlled failure of AIG serve as a model for systemically important financial firms. The banks that are today failing took on huge and foolish risks. (That "everyone was doing it" is a schoolboy’s excuse, not acceptable from people entrusted to manage trillions of other people’s money.) If as a consequence of their poor decisions, they now need money from the Federal government, we should demand that the taxpayer take effective ownership of the firm in exchange for the support. Regulators could then ensure a reorganization that promotes systemic stability while minimizing taxpayer costs, following which firms could be reprivatized in small, conservatively financed pieces that would no longer be "too big to fail".

Both the private sector and the public sector approaches presented here are workable, protect taxpayers’ interests, and avoid rewarding malefactors of great wealth with gargantuan public subsidies. The hybrid approach at the core of the Paulson Plan will result either in a serious cost to the taxpayers, or in future inflation as the Federal balance sheet is stretched to the breaking point and people lose confidence in US Treasury securities. (With a high enough rate of inflation, the Treasury can definitely turn a paper profit on any trash it buys from Wall Street, but that paper won’t be worth much. We could avoid a lot of foreclosures if we devalued the dollar by 50%.)

I am an independent voter. At the Presidential level, the Republican Party has already lost my vote. The last eight years have been catastrophic for the country, and accountability demands a change of party in the White House. At the Congressional level, however, my vote is up for grabs. Frankly, your response to the current financial crisis is my litmus test issue.

If there is any way I can be of service as you work through these difficult issues, I would be very honored to help. I thank you for your time and consideration.

Sincerely,
/s Steve Waldman

Brad DeLong made my day:

Nationalization has the best chance of avoiding large losses and possibly even making money for the taxpayer. And it is the best way to deal with the moral hazard problem.

It might work like this. Congress:

• grants the Federal Reserve Board the power to take any financial firm whatsoever with liabilities and capital of more than $25 billion that is not well capitalized into conservatorship

• requires the Federal Reserve Board to liquidate any financial firm in its conservatorship when it judges that the firm is insolvent (paying off in full or not paying off in full the liabilities of the firm at its discretion), unless the Federal Reserve Board finds that preservation as a going concern is in the interest of the taxpayer, in which case Congress grants the Federal Reserve Board the power to transform equity stakes in the firm into junior preferred stock at par value and then transfer ownership and custody of the firm to the Treasury

• requires the Federal Reserve to terminate conservatorship if the firm becomes well-capitalized once again.

In addition, Congress:

• grants the Treasury the power to issue up to $500 billion of troubled asset redemption bonds, the proceeds of which are then to be loaned to the Federal Reserve to be used to cover the liabilities of those liquidated firms that the Federal Reserve judges it is in the interest of the taxpayer to have their liabilities paid off in full.

…It’s time for the Democrats to pass a nationalization in the taxpayers’ interest bill and dare Bush to veto it.

There’s a beautiful irony here. The superficially private-sector-friendly Paulson Plan is likely to entail socializing losses and undermining the incentives that give capitalism its efficacy and its legitimacy. Outright nationalization, on the other hand, may look like a Commie statist plot, but strengthens the “invisible hand” in the long run, as long as the nationalization is temporary.

To understand the paradox, go back to Zingales’ excellent essay. Under ordinary circumstances, when firms can’t manage their debt, Chapter 11 reorganization is an excellent means of preserving market discipline while preserving the “going concern” value of the enterprise. Unfortunately, bankruptcy is a slow and uncertain process. In the current crisis, the insolvent enterprises are so large, numerous, and interconnected that financial markets might self-destruct if we “let nature take its course”.

Temporary nationalization could serve as a kind of fast-track bankruptcy. Creditors, counterparties, and customers would have some certainty that firms in conservatorship would continue to function, and most could expect to be made whole (although the state could and should force haircuts or debt-to-equity conversions on the some junior claimants). Stockholders and incumbent management would be unceremoniously booted from nationalized firms, creating a strong incentive for companies to avoid the state’s tender mercies if at all possible.

Besides reassuring counterparties, nationalization provides an opportunity for the government to restructure firms prior to reprivatization with an eye towards reducing systemic risk. “Too big to fail” firms can be sold off in pieces, rather than merged into superbehemoths with a government-arranged subsidy, as is the current fashion.

Of course, nationalization does represent a “taking” by the government of private sector assets. The salutary effect with respect to market discipline has to be weighed against a corrosive effect on property rights. But if the terms under which firms can be nationalized are reasonable and carefully spelled out, especially if nationalizations generally occur where firms otherwise would have fallen into bankruptcy, the harm to property rights would be minimal. Also, procedures and timetables for reprivatizing or liquidating nationalized enterprises would have to be built into the plan.

Nationalization is a hard sell politically. Small government, free-market types naturally have a problem with the Feds coming in and taking over stuff. But counterintuitive though it may be, overt nationalization is more consistent with the principles of a free market than covert government subsidy. Real capitalists nationalize.