FE Editorial : State and market

Written by The Financial Express | Updated: Sep 30 2008, 03:45am hrs
One of the prominent features of the current financial crisis in the US and UK is the return of nationalisationperhaps for the first time since the 1940sas a tool of government policy. This newspaper, fiercely committed to free-market principles, however, has been a consistent supporter of temporary nationalisation policies in this crisis. The reason is simple: this is an extraordinary systemic crisis, and a complete collapse of the financial system, a la The Great Depression of the 1930s, is what will actually lead to more statist economics in the longer termas it indeed did at the time of the Depression when state ownership of a whole lot of non-financial activities also gained currency and acceptability. This time around, quick action by government, including temporary nationalisation, will stave off a deeper crisis.

Any rescue of ailing financial firms must, of course, avoid creating moral hazardthis is safely ensured if the management and shareholders bear the brunt of their firms imprudence. A temporary nationalisation wipes out shareholders and usually sacks existing management and so, it meets the moral hazard test. It is, of course, plausible to argue that the same result can be achieved through a private takeover of an ailing firm at throwaway prices. This is, of course, true and is indeed the first best solutionin this crisis, JP Morgan bought Bear in the US, Lloyds bought HBOS in the UK. However, a private buyer may not always be forthcoming without assistance from the government, given the opacity and large quantities of toxic assets various firms may be holding. In such a scenario, the choice is clearbankruptcy or state rescue. Bailing out shareholders and management with cash transfers from the government is an invitation to moral hazard. Bankruptcy is an option if the firm is not so inter-connected with the rest of the financial systemLehman wasnt interconnected. In any other case, temporary nationalisation followed by a resale is the best option. In the case of Northern Rock and now Bradford & Bingley in the UK, nationalisation may become necessary to prevent a run on the banks from depositors. It is also important to remember another unique aspect of this crisis. More than depositors, banks are running on each other. In the complete absence of confidence in one anothers solvency, nobody is lending and wholesale money markets have dried up. Thus, rather damagingly, credit to the entire economy is drying up. The government has to intervene to stop this vicious cycle and reboot the smooth functioning of capitalism as we know it.