The answer: when we simply call it something else.

Nationalization of key large banks has been the talk for the past few weeks. This seems to be the dominant mechanism being discussed for a thorough restructuring of bank balance sheets. Harvard University economist Greg Mankiw suggests that in order to describe what is really meant by the process, you have to properly describe it.
If the government is to intervene in a big way to fix the banking system, “nationalization” is the wrong word because it suggests the wrong endgame. If banks are as insolvent as some analysts claim, then the goal should be a massive reorganization of these financial institutions. Some might call it nationalization, but more accurately it would be a type of bankruptcy procedure.
Megan McArdle at The Atlantic.com adds,
If nationalization is just a way to take control of the downsizing and ensure that equity shareholders and creditors don’t profit at the expense of the taxpayer, all well and good.  If it is a way to avoid recognizing the full extent of the losses as quickly as possible, not so much.

This confusion regarding what is meant by a possible nationalization highlights a key issue with the whole scheme. It doesn’t have a “playbook” or in other words there is no rule of law that covers the powers that must be exercised to complete such an action. If you are worried by the concept, you have a reason to be. It is because we have very little recourse against the arbitrary exercise of power should such action be taken.

This seems to be the biggest issue I have with those economists who are discussing the option. They discuss the mechanics of such action in the abstract, as if government is simply taking the role of a surgeon operating on his patient, rather than a political entity composed of conflicting ideologies and agendas devouring their kill.

The issue of politicization was taken up in a Wall Street Journal op-ed, “The Problem with ‘Nationalization’” last week. Given Washington’s track record of not doing what it started out claiming it would do in regard to the crisis, is there any reason to believe that what starts out as a “type of bankruptcy procedure” would not end up becoming institutionalized government encroachment in the financial sector?
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 criticized for inflating the rescue costs through its liberal loan-modification program. A money-center 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.

Mr. Geithner wants a public-private partnership to buy toxic assets from banks. All that government has done thus far has only scared private money off. As bankers now realize, when you turn to the government for financial assistance you take on an untrustworthy partner. Outside money will not come in only to see its investment diluted later on when the government injects additional funds.

Rather than focusing on ways in which we can further involve the government in the financial system, we need to find ways to extricate banks from government’s deadly embrace. Banks, at least the behemoths, were public-private partnerships before the crisis. Deposit insurance, access to the Fed’s lending, and the implicit (now explicit) government guarantee for banks “too big to fail” all constituted a system of financial corporatism. It must be ended not extended.
While the government currently ‘nationalizes’ banks as part of FDIC’s mandate, former FDIC head William Isaac points out that nationalization of one of our largest institutions is far beyond the scope and complexity of any nationalization ever attempted by FDIC.

The fact is that there is a process already covered by the rule of law meant for such instances, Chapter 11 bankruptcy reorganization or Chapter 7 liquidation. Yves Smith at naked capitalism argues that this is not an option for these large banks.
It’s hard to convey to people outside finance why a big complicated bank isn’t the same as a manufacturing business or a retailer, where you can resort to Chapter 11. The simplest explanation may be that banks are much more tightly integrated into various customer and counterparty webs than most other businesses are. If a big automaker wants to shut down a production line for a few hours or a week. it can be done with little disruption to outside parties if planned. It isn’t acceptable for a trading desk to shut down for a day, say to do “routine maintenance”. Counterparties would run for the hills the next chance they had a chance to initiate trades. Now one might argue that this is convention, but as a customer, not being able to trade, not having ready access to one’s funds is seen as an unacceptable risk, and that business requirement makes it impossible to resort to Chapter 11.

The short explanation of Yves point is that banks are supposedly special beasts. For instance, when an airline goes into Chapter 11, people are still willing to fly. There’s not much chance on any given flight that the plane will take off without fuel. However, banks use your money as “fuel”,” and there is a chance that if you give your funds to one in Chapter 11 that you might never see them again. As a result, bank bankruptcy has a confidence problem and risks a potential run.

I don’t buy it. Citi today is almost certainly insolvent. Given the government’s arbitrary actions in dealing with each problem as it comes along, there is a high level of uncertainty that any one party will be kept whole in a government led restructuring. Yet Citi continues to do business.

The key here is that a bad bank still consist of healthy operations which can be sold off intact as part of bankruptcy proceedings. In a free market, investment capital would seek out clean, vetted acquisitions of healthy chunks of these banks. Proven management teams who can perform adequate due diligence would field this capital to acquire portions of these banks. This would result in orderly transfers and recapitalizations of healthy portions of these banks, under rule of law.

Nationalization by any other name is still nationalization, because it is an arbitrary act of government, and as such unpredictable and uncontrollable. Instead of increasing arbitrary involvement of government in the financial sector, we need less government intervention.

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