In our open society, there are few words that people dare not speak. One such word in conversations about financial policy, however, is “nationalization,” meaning government ownership of large banks and other major financial institutions. Despite our squeamishness about the term, nationalization will most likely have to be done. Until the financial institutions at the center of the global trading system revive, the greater economy will be held hostage because lending will be crimped and financial market activity will be impaired. In a perfect world such a step would not be necessary. We are far from a perfect world.

To be sure, nationalization—the government ownership of the means of production—seems so last century. In fact, it seems so 1848, when Engels and Marx published the Communist Manifesto. Dialing the clock forward, the public, encompassing both the proletariat and the bourgeoisie, has registered three objections to the idea of the U.S. government taking an ownership stake in financial institutions. 

First, almost no one believes that the government can manage a business efficiently on an ongoing basis. This is a view informed by lines at the motor vehicle bureau and confusion between meters and feet at NASA. The care and maintenance of a complex financial firm requires expertise not normally available in the civil service.

Almost no one believes that the government can manage a business efficiently on an ongoing basis.

Second, even if a government-owned bank were run professionally, politicians would be sure to remind management of government ownership. The decisions over who is extended credit and on what terms would seem opportunities for doing good (for voters) that would be too attractive for politicians to miss. The result would be directed credit to the detriment of the firm’s bottom line, taxpayers, and economic efficiency.

These two objections explain why the public sector should not permanently own previously private firms. They are about the length of ownership—not that it should never be undertaken. That is why some analysts are talking about “pre-privatization,” or nationalization as the first step in bringing a revived firm back to market. 

A legitimate fear is that any policymaker clever enough to latch onto that branding opportunity, however, is also clever enough to make the transition as long as necessary to suit his or her interests. After all, who currently owns the mortgage giants, Fannie Mae and Freddie Mac? We, the people, do. And our elected officials do not seem in any particular hurry to change that situation. Any further nationalizations have to explicitly be temporary and with firewalls to protect from political interference.

Even if a government-owned bank were run professionally, politicians would be sure to remind management of government ownership.

The third and most powerful impediment to nationalization is the public’s inherent sense of fairness. When the government steps in to acquire a public corporation, it cuts into the line of claimants to the firm’s balance sheet. This line cutting creates capital gains and losses for private investors. With a suspicion borne of experience, people are rightly concerned that whether investors gain or lose is decided more by connections and logrolling than by economic efficiency and the original priority of the claims.

What is often neglected in discussions about the fairness of government intervention, however, is that the current prices of the market instruments of financial firms already include an assessment of if and how the government will intervene. That is, there may be some banks that are actually insolvent right now, but the possibility of a government rescue supporting existing shareholders is lifting equity values off the floor. Is it really unfair to wipe out those shareholders as nationalization might?

But there are also surely valuable banking franchises with share prices dragged down by the possibility that the government will elbow some shareholders out of the way at the corporate feeding trough. Wouldn’t a fair resolution protect those who kept their funds with such firms rather than dumping shares in a fire sale? 

Properly done, the resolution of a large complex financial institution need not be an exercise in unfairness. As a general principle for policy intervention, the government should attempt to create as few capital gains or losses for existing investors as possible, based on a plausible estimate of the long-term odds of government intervention and reasonable liquidation values for the firm’s assets. This can be done by imposing haircuts that neither completely wipe out nor fully protect the different classes of investors. 

As a general principle for policy intervention, the government should attempt to create as few capital gains or losses for existing investors as possible.

Investors betting solely on a government resurrection of a firm that is otherwise insolvent should face significant losses. The implicit odds they put on a bailout were too high to be sustained in a market economy. 

In establishing haircuts, officials must recognize that they are setting precedents. The perimeter of intervention will be difficult to shrink thereafter. Rewarding the bad behavior of management and the presumption of investors is not a welcome legacy for the future. But rewards should remain on the table for those who trusted their funds to firms with underlying value. 

This is a problem as old as the Republic. At Alexander Hamilton’s urging, the new constitutional government honored the pensions of Revolutionary War veterans. Some had doubted they would be paid and sold their pension claims to speculators, who fed those doubts along the western frontier. To Hamilton, the precedent of repayment was critical. Fairness was not about how the current holders of the debt fared but about the perceived willingness of the United States to pay its obligations. The fair price of Revolutionary debts was the one that built in a certainty of payment. That is, his sense of fairness was about the burden of his precedent on future generations.

Expecting the current Treasury Secretary to match the first might be hoping for too much. But Hamilton’s successor should have the same concern for precedent that signals a well developed sense of fairness for current and future generations.

Vincent R. Reinhart is a resident scholar at the American Enterprise Institute and a former director of the Federal Reserve Board’s Division of Monetary Affairs.

Image by Darren Wamboldt/The Bergman Group.