Yesterday the Treasury announced a raft of measures to rescue the financial system.  For once the hyperbole about finance being radically altered by this crisis was justified.  

Northern Rock is no longer being wound down but is now a big part of the government’s strategy to keep mortgage finance flowing.  How long it will remain a government bank is now anyone’s guess.

The Bank of England will be allowed to buy private sector assets, and is given permission to consider using freshly printed money to do this, if it needs to do so to avoid deflation.  This is a revolutionary step, introducing an new element of credit risk to the Bank’s balance sheet

The major banks’ toxic debt – above all mortgage-backed securities, but also corporate debt -  will be insured by the government in order to restart this essential part of our financial system.

And the FSA has effectively lightened the capital requirements in an explicit endorsement of a counter-cyclical approach to regulation.

What should an economic liberal think of all this?  The public debate about bailouts is often misleadingly black-and-white: to give to the wicked/stupid bankers, or not to give to the stupid/wicked bankers.  This belies the complex and systemic nature of banking, the variety of interests that have a stake in it functioning well, and the massive importance of incentives and expectations shaping its future.

A bailout is asked to meet a number of objectives, and failing on any of these opens it up to political criticism. 

It is meant to get the financial system working normally: the banks should not topple over. This would produce unbelievable difficulties: ATM’s seizing up, pay-checks cancelled, riot police in the street.  Money should flow in such a way that the real economy can function. 

Then it should be structured so that the tax payer is protected and ideally rewarded for the risks he is taking.   The projections for the national debt that were published in the pre Budget report were already scary.  They were almost certainly too optimistic: Darling thought the UK economy would start growing again in the autumn; the latest projections are far worse.  So we don’t need the taxpayer given yet more billions to shoulder.

It should also punish the existing shareholders – and possibly the people foolish enough to have lent to the banks previously, or bought their bonds, because better surveillance from them would have been helpful a few years ago. 

Finally, it is meant to offer some inkling of a pathway back to private ownership of banking.  It should not lead to a permanent politicization of finance, with all the productivity-destroying misallocations of capital that can result.

How you rank these objectives determines what you think of the bailout. John Redwood’s austere approach suggests scant regard for the first objective.  A forced deleveraging of RBS, regardless of the foreign origin of much of the lending, would be catastrophic for the financial system as a whole.  His overwhelming priority is protecting the taxpayer.  The approach seems like a good example of the Austrian economic theory that sees all the problem and solutions in terms of incentivising investment correctly.  Andrew Lilico, another Conservative blogger, sees things in much the same way.

Others, like Vince Cable, are keen to see a nationalization of banking.  It is the logical endpoint, so why not get there early and save us all from dithering?  It also deals with the perceived unfairness of the taxpayer taking all the risks while private investors make the upside.   Vince is scathing about the lack of strings attached to the previous £37bn investment, and their dithering over Northern Rock.

Vince has been famously prescient about much of this crisis to date.  He is right that getting lending restarted is more significant than any other factor. But his preference for nationalization obscures a number of difficulties. 

To start with, it is not the case that the private sector is taking no risks.  Earlier investors in these banks have taken a massive hit.  Neither does the taxpayer miss out on any upside. As well as the equity stake and punitively high rates on preference shares, a functioning banking system benefits the whole economy, of which the taxman gets about 40%.  So the current measures do not produce a horribly unjust division of risks and returns.

Nationalization also brings risks. Putting the £2trn of RBS assets and liabilities on the national balance sheet adds an element of volatility to our debt situation that might spook foreign investors, which we can ill afford (though, to be fair, those investors might see these assets as effectively guaranteed by the state anyway).  

Furthermore, no-one has shown how national ownership will boost lending.  Will ministers make lending decisions? How will it deal with acting as bailiff on bad loans? And, if the government demands that lending decisions should take place regardless of the possibility of losses, will this not badly undercut the profitability of the remaining banks?

Finally, what is the exit strategy?  Much is written about the “Greenspan Put” – the free insurance against a catastrophe that Alan Greenspan offered investors throughout his tenure at the Fed.  It is thought that by rescuing the market from its mistakes, he encouraged it to go on and make bigger and bigger bets.   These incentives certainly matter if finance is to resume on a responsible course. 

But governments should beware of other ways in which they might influence market expectations.  Nationalisation sends a powerful message to investors: you can be wiped out by government fiat.  So don’t invest here.  The very possibility of nationalisation is probably putting off those ‘vulture’ investors who might just have the money and the cojones to invest in the banks at this parlous time. 

Perhaps proponents envisage a period of national ownership and then an orderly privatisation.  But if that period of national ownership saw protracted, untypical lending to keep the whole economy going, how prepared for private ownership will the bank be?

My own view is that the government’s measures are broadly the right thing to do.  It is not prepared for the process of directly taking over lending activities to the private sector.  Yes, insuring the bank’s bad assets will cost something – although there will be an insurance premium to pay – but it produces nothing like the risks that direct ownership of the bank might produce.  Now is not the time to worry too much about taxpayer value for money. Guaranteeing the bank’s assets might ultimately make them stronger and better investment prospects.  Something else that might make them a better investment is the prospect of future inflation – which the Bank of England’s new powers might ultimately produce.  Combined with their much cheaper share prices, this might ultimately see them attracting the slugs of risk capital that they need to resume lending in a normal way.  

In these crisis times, there is a heavy premium on bold moves and dramatic gestures.  But I think we can be grateful that this Labour government does not see nationalization as the first course of action.

UPDATE (22nd January).  The FT's leader article seems also to agree that the latest measures are a good thing.  And Paul Myners, the City minister, seems similarly keen to keep the commercial option alive. 

"The capacity for soundly managed banks and markets to support the generation of wealth in the economy could never be matched by the public sector."