"We have made changes, Sire. Yes, it is true, we have made changes. But we have made them at the right time. And the right time is, when there is no other choice."
-- Conservative adviser to King Edward VII, explaining his support for liberal reforms
We may have just reached a critical turning point in American political economy -- not only in our efforts to overcome the burgeoning global banking crisis, but also to overcome the pernicious influence of free-market fundamentalism, which has dominated US economic policy for the last 30 years.
Ironically enough, the person who deserves more credit than anyone else for helping us to reach these goals is our current Treasury Secretary, a lifelong die-hard Republican and former Wall Street king-pin.
Last night, a few hours after the US stock market closed, the Bush Administration, embodied in Henry M. Paulson,Jr.,
announced
that in order to stem the continuing turmoil in capital markets, in
conjunction with other G-7 countries, the US federal government will
begin "as s
oon as we can" to use taxpayer money to buy preferred equity in private financial institutions, especially banks.
Depending on how it is implemented, this could very well amount to a partial nationalization of the entire US banking system by the US Government. Are you paying attention here, Hugo, Fidel, and Evo?
This marks a very sharp U turn in recent US policy. Indeed, just two weeks ago, in their September 23rd testimony before Congress, Paulson and Federal Reserve Chair Ben Bernanke dismissed such equity investments as a "losing strategy," compared to their preferred scheme, a government-run "reverse auction" to buy up to $700 billion of "toxic" bank assets.
HAIL MARY
This policy U-turn was not due to sudden new insights generated by careful academic analysis or some precise economic model.
It feels more like a Hail-Mary pass, coming at the end of one of the most disastrous weekly stock market performances in US and global history.
That, in turn, was preceded by ten exhausting days of political goat-rodeo and Congressional negotiations over the infamous "$700 billion bailout," on top of the preceding six exhausting months of more or less ad hoc, increasingly expensive but largely unsuccessful one-off interventions in money markets and the banking system by the US Treasury, the Federal Reserve, and a myriad other US bank regulators.
Meanwhile, there has been an even more quirky set of poorly-coordinated improvisational remedies administered by diverse regulators in the UK, Germany, France, Iceland, and Belgium.
At the end of all this, fear, uncertainty, and doubt (FUD) have continued to spread across global capital markets, as policymakers stumble into each other, national banking systems compete for deposits, the US Treasury becomes (ironically) a huge depository for safe-haven flight capital, and no one manages to get ahead of the crisis.
If the FUD continued to spread, and global credit remained on lock-down, the forthcoming global recession -- already likely to plunge real growth in Europe and the US to zero or less next year, China to 6 - 8 percent or less, and the rest of the developing world to 4-6 percent -- would become dire indeed.
So one answer to the riddle of Paulson's "sudden conversion" is that he simply had no alternative. Given that ad hoc bailouts, coordinated interest rate cuts, increased deposit insurance, the extension of government insurance and liquidity to money market funds, the commercial paper market, on top of the takeovers of AIG and Fannie/ Freddie, had not done the job, nationaliziation -- really internationalization, since global banks are involved, and other countries will presumably be asked to contribute -- is one of the few arrows left in his quiver.
A GREAT TRADITION
This will hardly be the first US experience with quasi-nationalization. On September 16, the Federal Reserve had effectively "nationalized" the giant insurance company AIG, acquiring 80 percent of its equity in exchange for an $85 billion loan.
Way back in the 1930s and 1940s, the US Reconstruction Finance Corporation seized and recapitalized many banks. The FDIC has also done this many times since then.
European governments have even longer histories of direct intervention in banking markets. And several of them moved almost too quickly in the last year to nationalize particular banks -- for example, the UK's Northern Rock in February 2008 and Fortis in September 2008.
Of course, most of these recent cases have involved failing institutions, where the government was a "lender of last resort." As discussed below, Paulson's plan is rather different.
Even farther back, in the early 19th century, states like Virginia and Pennsylvania often invested directly in state-chartered banks to set them up and keep them going. Those were not especially happy experiences with government ownership.
But this is hardly a great time for champions of private capital markets to be quibbling about the efficiency costs of government intervention -- private markets in the US alone have just lost $7 trillion of market cap in the last year, including $3 trillion in the last 3 weeks. And the global "opportunity cost" of the crisis is probably at least twice this high.
A GLOBAL RECOVERY FUND?
If done right, Paulson's PIP (Public Investment Program) will be much broader, more proactive and more innovative than previous bank nationalizations.
For example, one idea would be to establish a "Global Recovery Fund," permitting fresh private capital, "sovereign wealth funds" like those in Norway and the UAE, and European, Latin and Asian countries that have a clear stake in restoring the world's financial sector to health to invest alongside the US Treasury.
Even, Heaven help us, the IMF and the World Bank's IFC might participate in such a fund. They have run out of developing country crises to solve, are looking for a new role, and have $billions in untapped credit lines.
Such an approach would help to share the heavy burden placed on US taxpayers, and make this program more politically palatable than the TARP bailout proved to be.
A global fund would also help to diversify investment risks across many more countries and banks.
Indeed, the USG and its new partners might even become lenders of far-from-last resort, clearing the way for threatened but essentially-healthy institutions to survive the financial contagion, raise much more private capital as well, and, most important, turn each and every new $1 of equity into $10 to $15 of new lending.
If the fund is successful in reviving the world's financial system, and restoring banks to financial health, taxpayers and investors will no doubt all be paid back handsomely. But the most important benefits may be the "hidden" ones -- the catastrophic losses that would be avoided by preventing further chaos and market decline.
This is very different from Paulson's original TARP buy-back scheme, which promised to boost bank equity informally by way of overpaying for toxic assets with highly-uncertain values.
Ironically, that approach just rewards those companies with the very worst portfolios and lending practices, while enabling much less increased lending.
Indeed, TARP's only comparative advantage seems to have been that by avoiding direct government investment in the private sector, it did not violate any red lines of so-called free-market conservatives.
In hindsight, however, given TARP's birth pains, plus the fact that the market value of all US publicly-traded stocks fell from $12.9 trillion on September 19 to $9.2 trillion in the three weeks after Paulson Plan I was announced.
So respecting this neoliberal ideological taboo may well have just cost US investors -- most of whom are taxpayers -- at least $1 to $2 trillion of market value that might have been saved with an immediate recapitalization plan.
With that much extra dough, we could almost afford to wage another Iraq-scale war somewhere.
REMAINING ISSUES
The PIP program faces many challenges. It needs careful guidelines about how to value investments, which banks will be eligible, and how they will be incented to participate. There needs to be controls the propensity of Treasury officials to have "revolving door" relationships with the companies they are investing in.
It is also vital to focus on the program's central objective -- a temporary 
investment to stabilize the financial system, returning the investment
(hopefully with gains) to the Treasury as soon as possible.
The US Treasury also needs to decide what corporate rights we should get for our money.
For example, Mr. Warren Buffett, everyone's favorite wealthy investor these days, would probably demand protections against non-dilution and excessive dividends to other shareholders, and perhaps voting rights as well, if he were the investor. If taxpayers are investing and taking all this risk, why is Warren's money any more deserving of such rights than ours?
None of these issues are insurmountable. Furthermore, purchasing equity in established, publicly-traded institutions will certainly be a whole lot easier than setting up brand new, complex "reverse auction" markets for previously untraded mortgage-backed securities, much less insurance on them.
In any case, as we'll examine in Part II of this article, given the incredibly shaky structure of the global banking system's balance sheet, especially in the US and Europe, at this point Hank Paulson's public equity investment plan is really the US Treasury's only option for putting our banking system back on its feet.
So viva Comrade Hank! Y Viva la Revolucion!
But investors, workers, home owners, students, beware: it still pays to be conservative here, despite Hank's Revolution.
Because even if the government invest heavily in all these banks, no one is still quite sure what all those $trillions of asset-backed securities on and off their balance sheets are worth.
We may not find out until the housing market touches bottom and there are comprehensive audits of major financial institutions and their hedge fund buddies.
So keep at least some of your powder dry and hang on to your hats -- the ride will continue next week.
(c) SubmergingMarkets,
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