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The N-Word

In the brief weeks that Barack Obama has been president, the n-word has been heard with startling frequency in Washington. We're talking about “nationalization,” of course. The plight of the country's banks has become so severe that the GOP’s incessant cries of “socialism” during last year's campaign, so ridiculous then, suddenly seem too mild a description for the prospect we face. After all, nationalization sounds less like something Sweden would do and more like an order Hugo Chavez might issue during a rant against capitalism.

And yet Sweden did nationalize its banks, and we may have to as well––at least temporarily. Midway through Treasury Secretary Tim Geithner’s confirmation hearings last week, Chuck Schumer let loose with a startling revelation about the size of the hole in the banking industry: “I did a little calling this weekend to people who would know, and they said it could be three trillion dollars, four trillion dollars.” Wall Street’s senior senator then added: “I mean it just shakes our financial system, something that large.”

He ain’t kiddin’. For all the debate around it, the trillion-dollar stimulus bill currently winding its way through Congress is mostly a stopgap measure to prevent the current recession from becoming an outright depression. For growth to be self-sustaining, entrepreneurs must have access to start-up capital and established businesses need credit to cover operating costs and fund expansion. Unfortunately, none of this is possible when the banking system is broken; lenders sitting on piles of losses are loath to extend credit. Which is why the only question among economists is who will pay to clean up this mess, covering those losses so that credit can begin flowing once more.

Schumer’s observation came in the context of a discussion about a so-called good bank/bad bank proposal. The idea is that the government would pay private banks $3 to $4 trillion to take their bad debt off their hands, then park it in a government-owned entity (the so-called “bad bank”) in hopes of selling it off when its value improved. In the meantime, the banking industry would see its capital base replenished and could resume the business of lending. (This was the original idea behind the $700 billion Troubled Asset Relief Program, before the Bush administration abruptly changed course and began simply handing out cash.)

Alternatively, the government could seize––i.e., nationalize––the troubled banks, taking control of both bad assets and good ones. Once again, the rot would be cleaned out and housed in a separate entity, with the hopes of recouping its value later on. Before that, the government would pump up the banks with the necessary capital, then sell them back to the private sector. In this case, the bank’s owners––that is, its shareholders––would see their stakes wiped out. But their contribution, in the form of the banks’ remaining assets, would defray the cost of nursing the financial system to health.

There are, to be sure, practical objections to nationalization. For one thing, who would actually manage the banks once the government owned them? (Geithner and Larry Summers, the top White House economic aide, are both said to be discouraged by this problem.) And, absent clear conditions under which the Feds would take over any given bank, nationalization could easily provoke a panicked stock sell-off across the financial sector, as investors worried their bank might be next. Re-privatization alone poses huge logistical challenges (who’s eligible to buy, and at what prices?).

But, while thorny, these issues aren’t insurmountable. For example, an honest accounting of assets across the entire banking system would shine light on far more bad debt than we're currently aware of. But it would also reveal which banks are relatively healthy, reassuring investors that they’re not nationalization candidates. In any case, the bad-bank alternative is far less workable––it would require a far bigger outlay, money the government doesn’t currently have. That means issuing more debt and risking a collapse in the dollar and a devastating spike in interest rates. What’s more, the banks were the ones whose disastrous foray into the mortgage market created the financial crisis in the first place. Taxpayers should not have to fork over several trillion dollars simply to make their shareholders whole, as they would under the bad-bank option.

The worst course of action is the one we’ve taken up until now, gradually escalating capital injections and loan guarantees, preventing the banks from collapsing outright, but doing little to reinvigorate them. The Japanese spent the 1990s enacting similar half-measures, which spared them short-term political pain but cost them a decade of growth. And, in the end, they had to bite the bullet and administer the shock therapy anyway. Admittedly, “nationalization” is an ugly word, but it's a lot prettier than the alternatives.

This article appeared in the February 18, 2009 issue of the magazine.