Repeat After Me: It's A Solvency, Not A Liquidity, Crisis

Give Russell Roberts and Arnold Kling credit for at least being able to identity the current crisis as one of solvency rather than one of liquidity.

A liquidity crisis means assets lose value because of panic and distressed selling. The assets themselves are still inherently valuable, and given enough capital to tide the banks over, they should be able to survive and sell off the assets at something close to full value once the "market dislocation" ends. A solvency crisis means assets are actually worthless, or close to it. Insolvent banks become black holes (see Citi and AIG, which is a quasi-bank), as they pour capital into the gaping holes in their balance sheets. FDIC receivership is the best option for insolvent banks.

This is a distinction our government officials have apparently been unable to make. Bernanke and Geithner have both publicly stated that our financial system is suffering from a lack of liquidity. If this were true, the unprecedented liquidity the Fed and Treasury have injected into the system over the last six months would have ended the crisis.

I see three possible explanations for Bernanke and Geithner's apparent disconnect from other informed observers when it comes to assessing the banks: 1) they have honestly misdiagnosed this as a liquidity crisis, 2) they are afraid of the politics of nationalization, or 3) they wish to extinguish all alternatives before turning to nationalization because of the technical challeneges it poses. If the first explanation is true, they should both be replaced. If the second is the case, then David Axelrod should explain that given that conservatives from Alan Greenspan to Lindsey Graham have endorsed some form of temporary nationalization, there is more than enough political cover. And if the third is true, then I have two questions: why will the TALF work better than the TARP, and how much more expensive will nationalization be in six months time than it is now?

Can the Government Stimulate the Economy?

If two conservative economists discussed whether fiscal stimulus can ever work, and one exposed the debate as irrelevant to our current crisis, would the other even notice?

The answer seems to be no. Russell Roberts gives what he apparently believes is a deep and philosophical critique of Keynsian spending, arguing that government spending (G) effects consumption (C) and investment (I), such that an increase in G will lead to a decrease in C and I; they are more or less zero sum. Robert's argument rests on the assumption that an increase in G necessitates higher taxes, which individuals and businesses will factor into their spending and investment decisions, offsetting the effect of any higher government spending. This is recycled Treasury view masquerading as insight.

But then Arnold Kling exposes one of the fundamental flaws of the Treasury view: it assumes something close to full employment. When the economy is near full capacity, government deficits more or less would crowd out private investment. But when resources are being unemployed, this does not apply. And today we certainly have idles resources, between private capital sitting on the sidelines, pouring into short-term Treasuries, and unemployment itself rising above the equilibrium level.

Roberts seems oblivious to the implications of Kling's argument. The Dark Ages are quite dark, indeed.