The Obama administration is now completely wedded to the idea that there's nothing fundamentally wrong with the financial system - that what we're facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.
In a later post, Krugman went on to further clarify: there are two basic reasons for bank failures--the run on a sound bank is just one of them, and it's the one the Geithner plan is based on. But it's not the problem we're facing:
Why was I so quick to condemn the Geithner plan? Because it's not new; it's just another version of an idea that keeps coming up and keeps being refuted. It's basically a thinly disguised version of the same plan Henry Paulson announced way back in September. To understand the issue, let me offer some background.
Start with the question: how do banks fail? A bank, broadly defined, is any institution that borrows short and lends long. Like any leveraged investor, a bank can fail if it has made bad investments - if the value of its assets falls below the value of its liabilities, bye bye bank.
But banks can also fail even if they haven't been bad investors: if, for some reason, many of those they've borrowed from (e.g., but not only, depositors) demand their money back at once, the bank can be forced to sell assets at fire sale prices, so that assets that would have been worth more than liabilities in normal conditions end up not being enough to cover the bank's debts
Behind all the complex razzle-dazzle, this is the basic question here: what kind of bank failure do we have? And there really doesn't seem to be much question about that. The term "toxic assets" gives you all the answer you need: the problem is the assets themselves, not a run on basically sound banks. That's why the troubled banks can't be saved as they currently exist.
To keep the banks operating, you need to provide a real backstop - you need to guarantee their debts, and seize ownership of those banks that don't have enough assets to cover their debts; that's the Swedish solution, it's what we eventually did with our own S&Ls.
Now, early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that's an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.
This is the situation, but Geithner is unwilling or unable to face up to it. And so he's devised a clever scheme to try to hide what's going on. This, Krugman things, would be fatal, as,
I'm afraid that this will be the administration's only shot - that if the first bank plan is an abject failure, it won't have the political capital for a second.
This is a real example of irrational allegiance to an ideology. The viewpoint that we can't be experiencing the bad asset kind of bank failure--even though that's exactly what happened with the S&Ls--is both irrational and ideological. The empirical evidence is strongly against this viewpoint. Furthermore, the political consequences of failure would ordinarily ensure a more prudent alternative. It is the conceptual inability to break free of ideology that it as the very root of what the Obama Administration is doing right now. Which is made all the more ironic by Obama's repeated insistence that he is guided always by pragmatism and doesn't have an ideological bone in his body.
How would a true pragmatist handle this differently? Well, for starters, he would have an ideologically diverse group of advisers. Instead of having folks like Krugman, Galbraith, Roubini, Stiglitz, Baker, etc. all on the outside criticizing noisily in the public square, he would have at least some of them--or others who think like them--on the inside challenging Summers and Geithner every step of the way. This is a minimal requirement for avoiding group think. You have to actively seek diverse points of view--and then you have to make sure people are encouraged to speak out early and often. Otherwise, even those with diverse viewpoints may fall into self-censorship.
What difference would having such a diverse group make? It would obviously mean that Geithner's plan would not have been put forward. If it can't survive the snipping it's getting from afar, there's no way it could have survived internal debate. And that means we would have had some form of nationalization, which would have been both pragmatically sound in itself, and would have established the general moral principle of making those who took the risks shoulder the pain, rather than being bailed out by the innocent.
In turn, these two pillars--one pragmatic, the other moral, would have provided a strong foundation for the next crucial steps: re-regulating the financial system, and rebuilding the shattered economy. Cutting the losses and restoring moral order are not radical ideas. They are, in fact, if not conservative ideas, then surely prudential ones that conservatives should readily support. Thus, if Obama really does want to reach out to conservatives, this would be an excellent way to do it.
But reality does not play any part in any of this. Everything is wildly distorted by the funhouse mirrors of Versailles ideologies, turning everything in sight into its exact opposite.
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