On the nationalisation of the banks

Private Capitalism is a system that encourages innovation and risk-taking.  That allows Capitalist economies to grow rapidly.  But it also means that Capitalist economies are subject to ups and downs, because not every innovation works and not every risk turns out well.  In particular, when significant new innovations turn up, in Capitalist systems it quite frequently happens that people overestimate how quickly and by how much things will be changed by these new innovations.  That means that people either pay too much for the innovations at the start, or too many different people try to sell variants of the new innovation straight away.  This happened with the railways, with light bulbs, with radio, with dotcom firms.  Most recently it has happened with certain financial market innovations.

Why this happened with these particular financial innovations is an interesting and complicated question, which I have discussed elsewhere.  But the fact is that it did happen.  As a consequence of this (in combination with some other factors I again won't go into), banks and other financial institutions, around the world, have entered into some very bad deals and lost a lot of money.  Now the Market (the natural processes of market forces in a Capitalist system) would have dealt with this by identifying the firms (and individuals) that have lost the money and wiping them out, beginning with the most obvious and then, learning from information provided by the collapses of these firms, allowing the Market to identify the next firm that has lost and so on until the rottenness is cleaned out of the system.  That would mean financial firms collapsing, going into administration, being liquidated.

However, governments have been very fearful of what it would mean if financial firms started collapsing, and have not allowed that to happen.  Because firms have not been permitted to collapse, it has been very hard for the Market to heal itself.  A few weeks back, governments faced a choice: they could either

1. step back and allow the Markets to heal themselves, trusting that the results would not be disastrous and using government monies to smooth the social impact of the Market's cleansing work;
2. step forward and try to heal the situation using government means.

Governments chose to step forward.  They did not have faith in the Market.  Having chosen to step forward, with massive government expenditure behind them, governments must now make their schemes work.  The schemes announced so far may work (let us hope so).  But they will do so only if (a) they are sufficient to allow the Market to find the losers, so that government money can be used to heal; and (b) if significant additional negative shocks do not come.

I think the chances are that these schemes will not work.  Having gone down this government-steps-forward path, the next step will be widespread nationalisation of the banking system.  Since Private Capitalism is a system built on banks, that will represent the literal ending of Private Capitalism, and its replacement by State Capitalism - that is to say, the State will be the major provider of capital for investment in the economy.

But Private Capitalism, because it encourages risk-taking and innovation, allows economies to grow more rapidly.  So a move to State Capitalism will mean that developed world economies will grow more slowly.  That means that many debts that people have taken on in recent years, which assumed a certain rate of future growth in their wages, in the profits of their companies, or in the economy as a whole, will now prove unmanageable.  As well as the switch to State Capitalism meaning that economies will grow more slowly in the future, it will mean many additional bankruptcies in the short term.

This is not the end of the bad news.  For the switch to State Capitalism will involve, for Britain, the taking on of liabilities that would imply a very significant rise in government debt, and may be unserviceable.  That being so, widespread nationalisation of the banking system would probably involve one of three things: either

1. Liquidation of banks even after nationalisation;
2. Default (i.e. the British government may refuse to pay bills it has accepted responsibility for);
3. Inflation, to reduce the burden of the debt.

Inflation would be very difficult to achieve in the short term, and the effort to deliver it might run out of control.  It would be hard to justify widespread liquidation of banks after nationalisation - if the point were to liquidate, why bother nationalising?  So the most likely of these routes is default.  Hopefully that might be restricted to default on liabilities of the banks taken over (in practice these defaults would probably be branded as "renegotiations" or "restructurings" of the banks' liabilities).  A more widespread sovereign default would be a dark dark prospect.

So, nationalisation of the banking system is not a scenario we should contemplate with anything except considerable alarm.  But the clock is ticking on this.  I hope the bailouts work - as I've said before, nationalising all the banks (except presumably HSBC) would be a truly grim outcome.  But the chances are, sadly, slim.

None of this was inevitable.  The government has been sucked down this path by its lack of faith in the Market and by the lack of any articulated alternative strategy from anyone it considered worth listening to.  Collectively, the political classes have made this particular bed.  Now we will all have to lie in it.