By Greg Ip
Sunday, October 19, 2008
In the past month, the unprecedented has become routine. The Treasury Department and the Federal Reserve, headed by Republicans, have intervened in the U.S. economy to an extent that would have shocked liberals a year ago. The Treasury is now a major shareholder of U.S. banks, the Fed is a principal lender to private business, and the American taxpayer stands behind huge swaths of the financial system, from home mortgages to business bank accounts. "Socialism has now washed over free-market capitalism," Sam Donaldson of ABC News recently sighed.
Momentous? Sure. Socialism? Hardly. Breathtaking though these past weeks have been, they're nothing compared to what both the United States and other Western countries have experimented with in the past. But even though they have often departed from free markets in response to crisis, they eventually find their way back. Let's not get hysterical about changing the very nature of our system over the long haul. But in the meantime, don't rule out even more radical action.
Government ownership. You have to go back to the Great Depression and World War II to find examples of widespread U.S. government investment in private enterprise. But in other Western capitalist countries, nationalization was routine during the postwar period. Starting in 1946, Britain's Labor government nationalized transport, energy and communications companies, and by 1971, a Conservative government had taken over the failing automobile manufacturer Rolls Royce. At the peak, 10 percent of British economic output came from nationalized companies.
France, not surprisingly, went even further. When Francois Mitterrand's Socialists took power in 1981, they embarked upon a massive wave of nationalizations. The new government added 39 banks to those already owned by the state, putting 95 percent of the French banking system in government hands. "I am forced into retirement," declared a glum Baron Guy de Rothschild, head of the famed banking family's French branch. "I wish I could go on strike."
Unlike Mitterrand's moves, Treasury Secretary Henry M. Paulson Jr.'s partial nationalization of U.S. banks is driven by a need to keep the financial system intact, not a desire to take control of the means of production. In the 1990s, Japan and Sweden took over weakened banks and sold most of their stakes once the economy recovered.
If the current crisis deepens, Treasury's $250 billion passive investment -- which is less than a quarter of total bank capital in the United States -- could grow. And having said yes to banks, the government might find it hard to say no to buying stakes in other industries that also show up, cap in hand, or to other types of debt.
Fed loans. In total dollars, the expansion of Federal Reserve lending is actually larger than the price tag of the Treasury Department's actions. That might grow even further.
By law and tradition, the Fed is the lender of last resort, a role it fulfills by making short-term, secured loans to banks. But many of the firms whose failure threatens the entire economy nowadays aren't banks. A clause in the Federal Reserve Act lets the Fed lend to other types of firms -- under "unusual and exigent circumstances." Since March, Fed Chairman Ben S. Bernanke has routinely invoked this clause to let his institution help out investment banks, mortgage giants Fannie Mae and Freddie Mac, the insurer American International Group (AIG) and large companies that issue unsecured IOUs known as "commercial paper," such as General Electric.
It has been a huge change. Before the crisis began, the Fed had $868 billion of assets, 91 percent of them in innocuous Treasury bills and bonds. Now it has $1.6 trillion in assets, with less than 30 percent of them in Treasuries; the remaining assets are mostly in the form of loans to banks, securities firms, AIG, foreign central banks, commercial-paper programs and so on.
Could Bernanke go even further? He has promised to use "all of the powers at our disposal" to stop the credit crunch. As of June 30, loans to U.S. households, non-financial companies and state and local governments stood at $27 trillion. In theory, the Fed could supply all of this. But that doesn't mean that it should. At some point, Fed loans would keep alive borrowers that simply ought to fail. And the more credit the Fed extends now, the longer it will take to withdraw once the crisis passes -- a process that risks spurring inflation.
But the Fed could go quite a ways yet: Its $1.8 trillion in assets is equal to just 12 percent of America's gross domestic product. To battle deflation earlier this decade, the Bank of Japan stuffed Japanese banks with cash, hoping they'd lend it back out. At its peak, the Bank of Japan's balance sheet amounted to 30 percent of GDP. All this government effort didn't help much: Japan's banks were still so undercapitalized that they were reluctant to lend. But the Bank of Japan's exertions didn't trigger inflation, either.
Buy other assets. Ask the average congressman why he voted for the $700 billion bailout package, and he'll probably point to the sickening plunge in the Dow Jones Industrial Average. So would it be better for the U.S. government simply to buy stocks?
That's what Hong Kong did in August 1998 to combat speculative attacks on the territory's currency. By the time it was done, the Hong Kong Monetary Authority (its equivalent of the Fed) owned 7 percent of the shares in the territory's benchmark index. The dramatic move seriously dented the territory's laissez-faire reputation: Milton Friedman called it "insane." But it worked. Hong Kong's currency peg with the U.S. dollar survived, and Hong Kong made a profit. It remains a major shareholder.
Could Washington follow suit? The United States once routinely waded into foreign-exchange markets and is now intervening in the mortgage markets through its bailout of Fannie Mae and Freddie Mac. But buying stock is a bigger leap: There's a greater chance of capital loss, and outright purchases enmesh the government in issues of ownership (one reason investing the Social Security Trust Fund in stocks remains controversial). Though U.S. government purchases might drive up stock prices and help banks issue new shares to rebuild capital, they would not address the root of the credit crisis.
A more elegant way to use Washington's purchasing power would be to buy vacant homes and take them off the market to alleviate the downward pressure on housing prices. Of course, doing so without overpaying would be tricky indeed.
Stop trading. In a drastic recent step, the Securities and Exchange Commission temporarily banned "short-selling" of financial companies' stocks. Short-selling involves selling borrowed shares in hopes of replacing them later at a lower price -- in effect, a way of betting on a company's demise. Short-sellers do help keep markets honest, although corporate executives view them in much the same way as a starving man in a desert sees a gathering flock of vultures. Since many short-sellers simultaneously buy stocks or other securities, the SEC ban probably hurt the market more than it helped. The timeout opened up the door to the more radical idea, raised by Italian Prime Minister Silvio Berlusconi, of halting trading altogether.
The idea has precedent. In 1914, with war approaching in Europe, Treasury Secretary William Gibbs McAdoo feared that European countries would seek to raise funds by selling U.S. stocks and worried that the resulting outflow of gold would break the dollar's link to the metal. So he closed the New York Stock Exchange for four months, long enough for the newborn Fed to accumulate its own stash of gold to defend the dollar. William L. Silber, the author of "When Washington Shut Down Wall Street," argues that by keeping the United States on the gold standard, McAdoo's daring move helped establish the dollar as an international reserve currency to rival the British pound.
But McAdoo is not much of a model for today. Silber notes that stock-trading did not stop: An informal cash market in NYSE shares sprang up on a nearby street. Today, a trading halt would have to be global to be effective and would probably still be a bad idea: The inability to trade robs investors of vital information (not to mention access to their cash), which can cause more panic than even a sharply declining market.
The moral of all these stories is not just that far more radical action is available to the government. It's also that such bold steps are hardly irreversible. Even France's taste for ownership eventually waned. In 1986, conservatives began to sell off state-owned enterprises in part because some of them, especially the banks, needed capital. By the time the massive bank Crédit Lyonnais (nationalized in 1945) was privatized in 1999, it had cost the French government as much as $16 billion in bailouts. France has shown little taste for owning banks again. Under the bailout plan announced this past week, the French government will take stakes only in weak banks and sell them when the crisis is over.
A future U.S. administration may use its new ownership stakes to press banks to relent on foreclosures or lend more to favored constituencies. But ownership will also make Washington the target of demanding interest groups and disgruntled customers and shareholders if the banks stumble.
Indeed, while bankers' reputations are at a low ebb, Americans don't seem any more trusting of government as a result. In a Pew Research Center poll this month, 57 percent of respondents agreed that the government is "almost always wasteful and inefficient" -- up from 47 percent in December 2004. The odds are that once this crisis passes, the United States will return to its free-market roots, albeit with more regulations in place. But until then, things may get even wilder.
Greg Ip is U.S. economics editor of the Economist.