Tuesday, 10 February 2009

Nationalisation and the knowledge problem

In pure asset-allocation terms, nationalisation of bust banks seems to be the most reasonable option. Shareholders have taken big risks (or allowed their appointed representatives to do so), the risks did not pay off, and government now has to step in and help. Therefore, government should now own the banks.

I have broadly supported this argument, but it does hide a big problem: the knowledge problem. (There's a whole blog about this subject)

In order to best allocate economic resources, those who control them need to have knowledge about where they can get the best return. This knowledge is distributed all over a population of billions of people. Therefore how can we ensure the information can most quickly and reliably find its way to the person who controls the resource?

First we need to note that 'knowledge' is a tricky concept. At the risk of stepping through a vast minefield of epistemological thought, I'll assert that nobody knows anything about the world with absolute certainty. There are varying levels of confidence, conflicting views, self-delusion and simple gaps and errors in the information and beliefs that people have.

The market is a good (though hardly perfect) way of testing beliefs, finding which ones work and incentivising those with better information to apply it. And this is why Tim Geithner is so keen to ensure that the private sector has a stake in the toxic assets that the government is now acquiring. Market involvement helps to find an accurate price for debt, stakes in banks, and other assets - and this accurate price is the market's way of revealing all available information.

Government has other ways of gathering knowledge, and they are useful for certain things, but most people would agree that they are generally less effective than the market. If government ends up choosing the loan policy or marketing strategy of banks, it's likely that the resources will not go to the most productive places. I am well aware of the counter-arguments: a) bank management hasn't done a very good job in the past, and b) there are public goods and externalities which government will achieve better than private, competing banks. Nevertheless, the problem still remains. A future article will have more to say about this.

The hybrid public-private structure of the proposal not only saves money for the government, but achieves a reasonably equitable asset allocation while still retaining the informational advantages of market involvement.

Undoubtedly the solution is not perfect - but in a situation of limited meta-knowledge - knowledge about knowledge, and knowledge about the best solutions for the problems we face - it sounds like a reasonable proposal.

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