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!

Is President Obama up to solving the economic crisis?

Given that the bi-partisan cooperation hoped for by President Obama lasted all of perhaps 10 minutes, economist Paul Krugman is voicing a concern that many others have echoed: is Obama up to the task? From Krugman's column in the New York Times:

Mr. Obama’s victory feels more than a bit like defeat. The stimulus bill looks helpful but inadequate, especially when combined with a disappointing plan for rescuing the banks. And the politics of the stimulus fight have made nonsense of Mr. Obama’s postpartisan dreams...

In both the House and the Senate, the vast majority of Republicans rallied behind the idea that the appropriate response to the abject failure of the Bush administration’s tax cuts is more Bush-style tax cuts. And the rhetorical response of conservatives to the stimulus plan — which will, it’s worth bearing in mind, cost substantially less than either the Bush administration’s $2 trillion in tax cuts or the $1 trillion and counting spent in Iraq — has bordered on the deranged...

And the ugliness of the political debate matters because it raises doubts about the Obama administration’s ability to come back for more if, as seems likely, the stimulus bill proves inadequate...

Officially, the administration insists that the plan is adequate to the economy’s need. But few economists agree. And it’s widely believed that political considerations led to a plan that was weaker and contains more tax cuts than it should have — that Mr. Obama compromised in advance in the hope of gaining broad bipartisan support. We’ve just seen how well that worked...

Over all, the effect was to kick the can down the road. And that’s not good enough. So far the Obama administration’s response to the economic crisis is all too reminiscent of Japan in the 1990s: a fiscal expansion large enough to avert the worst, but not enough to kick-start recovery; support for the banking system, but a reluctance to force banks to face up to their losses. It’s early days yet, but we’re falling behind the curve.

Should we be worried?

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Congress fiddles as the world burns

Just when you thought we might actually be getting some real bi-partisan cooperation in Washington, D.C., apparently the Republicans are more concerned about scoring brownie points with a base still enamored of more tax cuts than coming up with a stimulus bill with the intent to avoid an economic meltdown. From an opinion piece by Nobel Prize winner Paul Krugman in the New York Times:

A not-so-funny thing happened on the way to economic recovery. Over the last two weeks, what should have been a deadly serious debate about how to save an economy in desperate straits turned, instead, into hackneyed political theater, with Republicans spouting all the old clichés about wasteful government spending and the wonders of tax cuts...

Somehow, Washington has lost any sense of what’s at stake — of the reality that we may well be falling into an economic abyss, and that if we do, it will be very hard to get out again.It’s hard to exaggerate how much economic trouble we’re in. The crisis began with housing, but the implosion of the Bush-era housing bubble has set economic dominoes falling not just in the United States, but around the world...

We’re already closer to outright deflation than at any point since the Great Depression. In particular, the private sector is experiencing widespread wage cuts for the first time since the 1930s, and there will be much more of that if the economy continues to weaken...

So what should Mr. Obama do? Count me among those who think that the president made a big mistake in his initial approach, that his attempts to transcend partisanship ended up empowering politicians who take their marching orders from Rush Limbaugh.

What matters now, however, is what he does next. It’s time for Mr. Obama to go on the offensive. Above all, he must not shy away from pointing out that those who stand in the way of his plan, in the name of a discredited economic philosophy, are putting the nation’s future at risk. The American economy is on the edge of catastrophe, and much of the Republican Party is trying to push it over that edge.

Yes, Rush Limbaugh (who, like Sean Hannity, dropped out of college before finding his calling in radio) can be very funny and his show is often quite entertaining. But for politicians to take their cues from an entertainer or celebrity (whether on the right or the liberal left) is the height of brain-dead irresponsibility.

Paul Krugman on the housing market

Princeton economist and New York Times columnist Paul Krugman is interviewed in the current issue of Fortune magazine. He's predicting housing price declines of 25% to 50% not based on the prices and incomes, but prices in relationship to potential rental income (which I also think is a much better barometer than incomes alone). So how bad does he think the mortgage crisis will get?

I think home prices will fall enough for us to produce about 20 million people with negative equity. That's almost a quarter of U.S. homes. If home prices are rising, or if there's positive equity, you can refinance or sell. But if you have negative equity, you can end up being foreclosed on, and then some people will just find it to their advantage to walk away...

I still think the estimates people are putting out there - $400 billion or $500 billion in losses - are too low. I think there'll be $1 trillion of losses on mortgage-backed securities showing up somewhere...

My preferred metric is the ratio of home prices to rental rates. By that measure, average home prices nationally got way too high. We'll probably basically retrace all that. So that's about a 25% decline in overall home prices. Only a fraction of that's happened so far. Of course, it varies a lot. In places like Houston or Atlanta, where home prices have not risen much compared with underlying rents, the decline will be relatively small. In places like Miami or Los Angeles, you could be looking at 40% or 50% declines...

And yet, that will still vary greatly depending on location, product type and the existing relationsihp between prices and potential rents.

People at the Fed are talking about feedback loops. At the moment, most of what they're concerned about is that falling home prices are leading to a credit crunch, which is actually driving up mortgage rates and making mortgages unavailable, which is causing home prices to fall even more. I'm not one of those people who thinks the Great Depression is coming back, but there's lots of echoes...

The financial stuff looks like a combination of 1990 and 2001, and probably bigger than both combined. You've got the financial disruption, which is probably bigger than the savings and loan crisis. And you've got the loss of wealth from the housing bust, which is bigger than the dot-com bust. So this looks fairly nasty. And then everybody who's paying attention is worrying about the Japan analogy. Japan never had a really severe recession. It just started with a recession and never really had a recovery for a whole decade. And that's the kind of thing we're afraid of...

The effective borrowing costs for a lot of people are rising, not falling, despite the Fed cuts. The rising spreads are more than offsetting it. The mortgage rates have not been falling as you might hope. And, of course, for many types of people who were able to borrow two years ago, they now can't - at any interest rate. We're looking at the classic pushing-on-a-string problem, where the Fed can cut, but it's not clear it does much for the real economy...

What Greenspan did not do was listen to warnings about subprime. The Fed had substantial regulatory and moral-suasion power. They could have done a lot to limit the excesses. It's more what he failed to do during the boom than what he did in response to the last slump...

The inflation happening right now is not being fed by expectations of inflation - there's no self-reinforcing process - it's just mostly commodity prices going through the roof. That's not pleasant, but it's not something the Fed needs to be all that worried about, as long as it stops there...

I look at the euro at $1.53 and cheer - not for this European trip I'm planning to take after classes are done. But for manufacturing plants in the Midwest, it's a very good thing. Arguably the only good thing we have going for the U.S. economy now is the weak dollar and how that helps exports...

I'm looking at the increase in interest-rate spreads, with the LIBOR (London interbank offered rate) pulling away from U.S. Treasury bills. When the spread gets that big, it suggests that banks are losing trust in each other. Various measures of panic in the markets are looking bad again. I've been thinking to myself, This is now the fourth wave. We had a first wave more than a year ago, when subprime first began to go. And everyone said that was contained. We had a second wave last August, when things started going to hell. We had a third wave late in the fall, and heroic efforts seemed to bring the problems under control. And now here we go again. This is starting to look like a much more comprehensive financial crisis...

It seems to me like every few weeks there's another $300 billion market I've never heard of that has just collapsed. And there's credit cards, auto loans - I don't know what's next. But it's clear we're going to have a commercial real estate crash not too far short of the severity of the housing crash...

If you look historically at other financial crises, they typically end up with big government bailouts. But how's that going to work in this case? We don't even know who to bail out. And part of the problem is we don't even know who owes what to whom...

How much in the end does the ability of consumers to keep spending get affected by what's going on in fairly abstruse financial markets? So I'm not quite sure how this works. Maybe that's a reason for hope. Maybe it'll turn out that all this Wall Street stuff is just less important than we think it is.