Krugman on Geithner's plan: "Financial Policy Despair"

Nobel-winning economist Paul Krugman is none too pleased with the latest plan by the Obama Administration to address the financial crisis. From his New York Times column:

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.

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...

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...

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But 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.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

Ouch!

Economist Krugman seconds the call to nationalize banks

New York Times columnist and economist Paul Krugman seconds Nouriel Roubini's call to nationalize the nation's largest banks, laying out his case in plain English. From his column:

The case for nationalization rests on three observations.

First, some major banks are dangerously close to the edge — in fact, they would have failed already if investors didn’t expect the government to rescue them if necessary.

Second, banks must be rescued. The collapse of Lehman Brothers almost destroyed the world financial system, and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.

Third, while banks must be rescued, the U.S. government can’t afford, fiscally or politically, to bestow huge gifts on bank shareholders...

To end their zombiehood the banks need more capital. But they can’t raise more capital from private investors. So the government has to supply the necessary funds.

But here’s the thing: the funds needed to bring these banks fully back to life would greatly exceed what they’re currently worth. Citi and BofA have a combined market value of less than $30 billion, and even that value is mainly if not entirely based on the hope that stockholders will get a piece of a government handout. And if it’s basically putting up all the money, the government should get ownership in return...

The real question is why the Obama administration keeps coming up with proposals that sound like possible alternatives to nationalization, but turn out to involve huge handouts to bank stockholders...

How would nationalization take place? All the administration has to do is take its own planned “stress test” for major banks seriously, and not hide the results when a bank fails the test, making a takeover necessary. Yes, the whole thing would have a Claude Rains feel to it, as a government that has been propping up banks for months declares itself shocked, shocked at the miserable state of their balance sheets. But that’s O.K....

What we want is a system in which banks own the downs as well as the ups. And the road to that system runs through nationalization.

Does the U.S. need to heed the advice it once offered Japan?

When Japan's banking system had its own meltdown in the early 1990s, the advice offered by the U.S. was to admit the damage, take corrective action and move on. Now, in a deja vu reminiscent of some Greek tragedy, the U.S. banking system finds itself in similar peril, a story in the Wall Street Journal suggests that sometimes the best advice is that which finds it way back to the source:

When Japan was mired in economic crisis, the U.S. urged it to take decisive action to deal with its ailing banks. Japan didn't follow the advice and the crisis dragged on for years. Now, it is the U.S. that is mired in crisis and facing the prospect of swallowing the bitter medicine it once proffered...

Japan's stock-market bubble began rapidly deflating in 1990 and its property bubble followed suit shortly afterward. Many borrowers were unable to make payments on their debt and bad loans piled up on bank balance sheets. A long period of lackluster economic growth made a tough situation worse. With the financial system saddled with bad debts, Japan desperately needed its banks to acknowledge the severity of their problems and for some banks to shut their doors. But the banks, unwilling to take steps that might render them insolvent, refused to acknowledge their problems, extending the crisis...

Still, U.S. financial firms have been much quicker to acknowledge losses than their Japanese counterparts were. While the slicing and dicing of mortgages into tradable securities played a part in the mortgage mess, accounting rules make it difficult for firms to ignore losses on those securities, says Princeton University economist Hyun Song Shin. In contrast, by continuing to extend credit to bad borrowers, Japanese banks were able to put off recognizing the extent of their debt problems.

"The denial strategy is harder to pull off -- it will catch up to you in the accounting," says Mr. Shin. "That's one of the more encouraging and hopeful signs in the U.S."...

One last problem the current U.S. situation shares with Japan in the 1990s may be a financial sector that is far larger than it should be. "If you have an unsustainable lending boom, then by definition the lending has to shrink," says Adam Posen, a deputy director at the Peterson Institute for International Economics in Washington.

In Japan, that didn't happen. Rather than failing, troubled banks merged with healthier ones. But even though the combined bank would often end up with branches that were within steps of one another, few bank workers lost their jobs. Mr. Posen worries that concerns about the systemic risk to the financial system will prevent the U.S. from allowing enough firms to shut their doors to make the necessary capacity cuts.

In that regard, the tougher line with Wall Street that U.S. officials took over the weekend is encouraging. Refusing to financially backstop a takeover of Lehman Brothers Holdings Inc. with government money, as they did for J.P. Morgan's hasty acquisition of Bear Stearns, they showed they were far more willing to let a troubled firm fail than their Japanese counterparts were. Also, many financial firms have already begun cutting operations in a way Japanese banks balked at...

Quickly shrinking the financial sector could have a social cost, as well, putting tens of thousands of people out of work. Where will they go?