Babies With Candy V

Krugman opines The Big Dither

Here’s how the pattern works: first, administration officials, usually speaking off the record, float a plan for rescuing the banks in the press. This trial balloon is quickly shot down by informed commentators.

Then, a few weeks later, the administration floats a new plan. This plan is, however, just a thinly disguised version of the previous plan, a fact quickly realized by all concerned. And the cycle starts again.

Why do officials keep offering plans that nobody else finds credible? Because somehow, top officials in the Obama administration and at the Federal Reserve have convinced themselves that troubled assets, often referred to these days as “toxic waste,” are really worth much more than anyone is actually willing to pay for them — and that if these assets were properly priced, all our troubles would go away.

While Krugman may not find the plans credible, there are certainly informed commentators who do. He is certainly not the only political commentator dismissive of those who disagree with him.

A more rigorous analyst would question the process.

While it may well be true that bold steps are required, its hard to imagine that any set of bold steps will be greeted without resistance by "informed commentators". To give "informed commentators" a policy veto is to preclude adopting bold steps.

Its clear that the administration is attuned to the politics. It is natural for political policy makers to be attuned to the political implications of policy. It also may reflect sympathy for the school of thought which believes recessions to be, above all, crises of confidence and the way out of recessions to restore confidence. Bold steps, in that view, are less medication than placebo; The actual steps are less important that the public's confidence in them.

Krugman, to my mind, also mis-states the motivation behind the policies. The concrete problem that the administration is trying to address is the banks have on difficult to price, and therefore "toxic", assets on their balance sheets that impair their ability to serve their nominal economic role. Were we to price these assets at their current, fire sale, market price most of these banks be seriously under capitalized, if not insolvent. Its reasonable to believe that getting these assets off bank balance sheets at an non-ruinous price will go along way towards pushing our troubles away.

Thus, in a recent interview Tim Geithner, the Treasury secretary, tried to make a distinction between the “basic inherent economic value” of troubled assets and the “artificially depressed value” that those assets command right now. In recent transactions, even AAA-rated mortgage-backed securities have sold for less than 40 cents on the dollar, but Mr. Geithner seems to think they’re worth much, much more.

And the government’s job, he declared, is to “provide the financing to help get those markets working,” pushing the price of toxic waste up to where it ought to be.

Geithner is certainly right to a point.

These assets being loans, have a long-term value: Some amount of money will be paid back. In healthy, liquid markets, the market price is the best estimate available of the expected long-term-value. The current market prices are almost certainly depressed, as they more reflect fear of short term price fluctuations. An investment manager who has to mark her portfolio to market and report P&L to clients on a monthly, or quarterly, basis and whose clients are likely to substantively withdraw money in response to paper losses, is rationally more concerned with short-term-price rather than long-term-value expectations.

To the degree that our economy depends on these markets functioning, the government has a responsibility to help get those markets working again.

Financing buyers, however, is not, to my mind, really a means to get these markets working again. The price will be dependent on the terms of the financing. To work, I think, Geithner will have to set the terms such that the price approaches the long-term-value. A price set too high will save the banks, but not restore investor confidence in price stability. Krugman is right to question Geithner's -- any individual's -- ability to gauge that long-term-value.

A more thoughtful policy would be to adjust tax policy to encourage investment pools with longer lockups, and with P&L measured in cash returns not market values. The price managers of those pools would be willing to pay for assets will be far more based on expectation of long term value.

That said, if the goal is getting these assets off bank balance sheets as quick as possible, subsidizing buyers may well be the most sensible policy.

...The truth is that the Bernanke-Geithner plan — the plan the administration keeps floating, in slightly different versions — isn’t going to fly.

Take the plan’s latest incarnation: a proposal to make low-interest loans to private investors willing to buy up troubled assets. This would certainly drive up the price of toxic waste...

But would it be enough to make the banking system healthy? No.

Think of it this way: by using taxpayer funds to subsidize the prices of toxic waste, the administration would shower benefits on everyone who made the mistake of buying the stuff. Some of those benefits would trickle down to where they’re needed, shoring up the balance sheets of key financial institutions. But most of the benefit would go to people who don’t need or deserve to be rescued.

And this means that the government would have to lay out trillions of dollars to bring the financial system back to health, which would, in turn, both ensure a fierce public outcry and add to already serious concerns about the deficit...

Krugman's argument appears to be: Subsidizing private investors will not make the banking system healthy because benefit will be going to undeserving people. While, perhaps, rhetorically appealing, it is logically empty.

Krugman believes that de-zombification will make banking system healthy (I am skeptical). If these toxic assets on zombie bank balance sheets are replaced with enough cash, the banks will be de-zombified.

That cash can come from the government -- per Paulson's initial plan or proposed nationalization schemes -- or from subsidized, if undeserving, private investors (the subsidy is required because private investors are not currently willing to pay sufficient cash).

So why has this zombie idea ... taken such a powerful grip? The answer, I fear, is that officials still aren’t willing to face the facts. They don’t want to face up to the dire state of major financial institutions because it’s very hard to rescue an essentially insolvent bank without, at least temporarily, taking it over. And temporary nationalization is still, apparently, considered unthinkable.

Krugman has yet to explain how nationalization is a panacea. In a vanilla nationalization model, the government will replace these toxic assets on zombie bank balance sheets with sufficient public capital, then sell the recapitalized banks and toxic assets separately into the market over some period of time.

This seems to me, on the surface, to be far a more complicated, risk laden and expensive means to the same end as a well calibrated buyer subsidy. Which more simply explains this idea's powerful grip.

One suspects that Geithner, with a much better view of the matter, understands the dire state of major financial institutions far better then Krugman. And it may well be the very dire-ness and attending expense of recapitalization, that precludes Geithner, as Paulson before him, from considering a public-capital-only solution.