Babies With Candy 3/22

Catching up Financial Policy Despair

This is a mostly repetitive column. Krugman's tone getting increasingly more shrill as it appears Obama will not adopt the policy he prefers.

...Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy — specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

...now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

These plans, as observed here previously assume no such thing. Rather, they assume that the economy would be healthier if the banks were healthier, that the banks would be healthier if they had more cash and fewer toxic assets, that the cash the private sector is currently willing to provide in exchange for those toxic assets is not enough to restore the banks to help, but that with government incentives the private sector will provide sufficient cash.

There are good reasons to be skeptical about a number of these assumptions, but they are all far more solid then "bankers know what they are doing"

...Right now, our economy is being dragged down by our dysfunctional financial system, which has been crippled by huge losses on mortgage-backed securities and other assets.

This is a semi-truth. For a good 10 years before our economy was dragged down by a supposed dysfunctional financial system it was inflated by a government encouraged hyper-functional one. We have 10 years of economic growth that may well be every bit as real as Madoff profits.

Given that, its not clear to me that the financial system is entirely dysfunctional. What would be the response of a functional financial system to the recognition that it was flooded -- from housing, to student loans, to credit cards, to corporate financing -- with bad debt?

Put differently: Are our economic troubles a symptom of the financial system clamping down on credit dragging or is the credit crunch an inevitable consequence of an economy in which the repayment of too much debt was entirely dependent on increasingly easy credit?

If it is the former, the policies being pursued to "ease" credit are sensible. If it is the latter then such policies will prove cataclysmic.

As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now.

Its not clear to me that governments have, for centuries, been pursuing these policies.

As argued here before, one reason why doing this now might now might not be sensible is scale. Does the government really have no reason not to want to put all that bad debt on the federal balance sheet?

Also, given the scale, if the government takes "temporary" control over citibank it will likely find itself in long term control of Morgan Stanley.

Truly insolvent is a fuzzy word in this context. It will be a long time till we know the true value of many of the toxic assets and, so, whether or not a given bank was insolvent. On the other hand, a bank that loses the confidence of the market and so can't raise capital is, simply, insolvent. The more banks the government nationalizes the less confidence the market will have in the survivors and, therefore, the less solvent they will be. In other words, a policy of nationalizing banks will render banks that are absent that policy solvent, trully insolvent.

The temporary notion is downright silly. Control can be temporary if there are markets to sell assets into. But if the government seizes the largest banks there will be no such markets. Control, therefore -- even without the likely political meddling -- will be inevitably long term.

...The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels... Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama’s top economic adviser, is to use “the expertise of the market” to set the value of toxic assets.

Again, this assumption is besides the point. None of these plans care about the true value of these assets as much as getting them off the balance sheets of banks at a price that won't bankrupt all the banks.

I am, certainly, giving Geithner a bit of the benefit of the doubt here. But as much as I am skeptical of his competence, I have a hard time imagining the he hasn't figured out that the value a market assigns is a strong function of the financing available to market participants. He has to know that, by the terms of the offered financing, he -- more than the expertise of the market -- will be substantively setting the price. The idea then, must be to get these assets of bank balance sheets and into private hands better suited to hold on to them.

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.

This is an oversimplification and misrepresentation of the payouts. Depending on how much investors have to put down, they won't walk away if it simply goes down a little. The investors therefore own the first chunk of loss. On the other side, the Government, by virtue of being owed interest payments, owns the first chunk of gain. The Government even profits if the value decreases slightly.

While this seems a reasonable deal for the government -- especially given the primary goal is to clear assets from bank balance sheets, not profit from financial transactions -- I suppose one could argue. It borders on mindless, however, to brand it a one way bet.

...By my count, this is the third time Obama administration officials have floated a scheme that is essentially a rehash of the Paulson plan, each time adding a new set of bells and whistles and claiming that they’re doing something completely different. This is starting to look obsessive.

The technical term for this, I think, is projection. The administrations flip flopping policy is anything but obsessive. Krugman's commentary on the other hand.

The administration flip-flops are likely a result of the politics. The administration would prefer avoid the political cost of another expensive bank bailout. On the other hand, the administration cannot bear the political cost of the DOW dropping to 6500 and below. When the markets are in free fall these plans are introduced, when they stabilize they are shelved.

But the real problem with this plan is that it won’t work... the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact...

I do love Krugman-the-economist who, in most every column, feels the need to undermine Krugman-the-political-columnist.

It was not merely a few financial executives that bet their banks on the belief that unprecedented levels of household (and corporate) debt were no problem, it was the industry as a whole. In fact, it wasn't simply private industry, but government policy makers. They, we, all lost that bet, and are left with a truly insolvent economy as opposed to just a few banks that are truly insolvent.

Given the real problem, then, Krugman's partisan proposal solves little.