Krugman: Absolute Wage Levels Matter Too

Economists usually talk about relative prices. If wages and prices all double in an economy, then an individual's consumption choices will not change. But this view of relative prices ignores the impact of fixed costs, particularly of debt. If wages and prices fall commensurate levels, the purchasing power of an individual should be unchanged - unless that individual wracked up excessive levels of debt when wages and prices were higher. In that case, the individual will need to devote a greater percentage of his income to servicing that debt than he did when his wages were higher. The collateral he used to secure the debt - say a house in the case of a mortgage - might be worth less than the value of the loan with general deflation across the economy, so he cannot sell what he owns to get out from under the debt. This is debt deflation.

Paul Krugman reminds us of the veritable economic horrors of debt deflation and the implicit importance of nominal wages in his latest column. From the New York Times:

And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.

Just a reminder that as bad as the 1970s were, if we face a choice between stagflation and a deflationary spiral, it's really no choice at all.

Geithner Is Wall Street's Guy

Should we bring back the Geithner Death Watch? This New York Times profile in regulatory capture certainly sets up the it-was-Geithner's-fault narrative if the economy dramatically worsens. Some of the highlights from the article, with between the lines translations:

Last June, with a financial hurricane gathering force, Treasury Secretary Henry M. Paulson Jr. convened the nation’s economic stewards for a brainstorming session. What emergency powers might the government want at its disposal to confront the crisis? he asked.

Timothy F. Geithner, who as president of the New York Federal Reserve Bank oversaw many of the nation’s most powerful financial institutions, stunned the group with the audacity of his answer. He proposed asking Congress to give the president broad power to guarantee all the debt in the banking system, according to two participants, including Michele Davis, then an assistant Treasury secretary.

The proposal quickly died amid protests that it was politically untenable because it could put taxpayers on the hook for trillions of dollars.
“People thought, ‘Wow, that’s kind of out there,’ ” said John C. Dugan, the comptroller of the currency, who heard about the idea afterward.

Translation: Geithner wanted to put taxpayers on the hook for all the mistakes bankers, their counterparties, and their bondholders made, with no real upside for the public. Is a more bank-friendly proposal possible? Back to the piece:

Mr. Geithner was particularly close to executives of Citigroup, the largest bank under his supervision. Robert E. Rubin, a senior Citi executive and a former Treasury secretary, was Mr. Geithner’s mentor from his years in the Clinton administration, and the two kept in close touch in New York.

Mr. Geithner met frequently with Sanford I. Weill, one of Citi’s largest individual shareholders and its former chairman, serving on the board of a charity Mr. Weill led. As the bank was entering a financial tailspin, Mr. Weill approached Mr. Geithner about taking over as Citi’s chief executive.
But for all his ties to Citi, Mr. Geithner repeatedly missed or overlooked signs that the bank — along with the rest of the financial system — was falling apart. When he did spot trouble, analysts say, his responses were too measured, or too late.

Translation: Despite being so close to Citi officials that they wanted him as CEO, he was clueless as to how much trouble there were in. This is a nice double whammy: show that Geithner was close - too close - to the bankers he was supposed to be supervising, and then that he was ineffective at supervising them. Was he unaware because his closeness compromised his judgment, or simply because he was not good at his job? Back to the article:

To Joseph E. Stiglitz, a Nobel-winning economist at Columbia and a critic of the bailout, Mr. Geithner’s actions suggest that he came to share Wall Street’s regulatory philosophy and world view.
“I don’t think that Tim Geithner was motivated by anything other than concern to get the financial system working again,” Mr. Stiglitz said. “But I think that mindsets can be shaped by people you associate with, and you come to think that what’s good for Wall Street is good for America.”

Translation: Geithner is a textbook example of regulatory capture. Back to the article:

In a May 15, 2007, speech to the Federal Reserve Bank of Atlanta, Mr. Geithner praised the strength of the nation’s top financial institutions, saying that innovations like derivatives had “improved the capacity to measure and manage risk” and declaring that “the larger global financial institutions are generally stronger in terms of capital relative to risk.”

Two days later, interviews and records show, he lobbied behind the scenes for a plan that a government study said could lead banks to reduce the amount of capital they kept on hand.

While waiting for a breakfast meeting with Mr. Weill at the Four Seasons Hotel in Manhattan, Mr. Geithner phoned Mr. Dugan, the comptroller of the currency, according to both men’s calendars. Both Citigroup and JPMorgan Chase were pushing for the new standards, which they said would make them more competitive. Records show that earlier that week, Mr. Geithner had discussed the issue with JPMorgan’s chief, Mr. Dimon.

At the Federal Deposit Insurance Corporation, which insures bank deposits, the chairwoman, Sheila C. Bair, argued that the new standards were tantamount to letting the banks set their own capital levels. Taxpayers, she warned, could be left “holding the bag” in a downturn. But Mr. Geithner believed that the standards would make the banks more sensitive to risk, Mr. Dugan recalled. The standards were adopted but have yet to go into effect.

Translation: Geithner is a fool - perhaps what Rubin would call a useful idiot - who shilled for the bankers. While Geithner was hardly alone in believing that derivatives helped manage risk by spreading it to those most able to bear it, pointing out that he still trumpeted their virtures in 2007 makes him look rather clueless. And if Geithner really believed that lowering bank capital levels would make them more cautious and sensitive to risk, rather than simply more vulnerable to any downturn, then I have a Nigerian friend for him who can help him score big if he'll just send a check. Back to the piece:

In making the Bear deal, the New York Fed agreed to accept Bear’s own calculation of the value of assets acquired with taxpayer money, even though those values were almost certain to decline as the economy deteriorated. Although Fed officials argue that they can hold onto those assets until they increase in value, to date taxpayers have lost $3.4 billion. Even these losses are probably understated, given how the Federal Reserve priced the holdings, said Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago. “You can assume that it has used magical thinking in valuing these assets,” she said.

Translation: This paragraph doesn't even require any between the lines reading; it explicitly says that Geithner accepted Bear Stearns' fake values for assets, with the taxpayers making up the difference. Back to the article:

Over Columbus Day weekend last fall, with the market gripped by fear and banks refusing to lend to one another, a somber group gathered in an ornate conference room across from Mr. Paulson’s office at the Treasury.

Mr. Paulson, Mr. Bernanke, Ms. Bair and others listened as Mr. Geithner made his pitch, according to four participants. Mr. Geithner, in the words of one participant, was “hell bent” on a plan to use the Federal Deposit Insurance Corporation to guarantee debt issued by bank holding companies.
It was a variation on Mr. Geithner’s once-unthinkable plan to have the government guarantee all bank debt.

The idea of putting the government behind debt issued by banking and investment companies was a momentous shift, an assistant Treasury secretary, David G. Nason, argued. Mr. Geithner wanted to give the banks the guarantee free, saying in a recent interview that he felt that charging them would be “counterproductive.” But Ms. Bair worried that her agency — and ultimately taxpayers — would be left vulnerable in the event of a default.

Mr. Geithner’s program was enacted and to date has guaranteed $340 billion in loans to banks. But Ms. Bair prevailed on taking fees for the guarantees, and the government so far has collected $7 billion.

Translation: The vast guarantees of bank debts were Geithner's brainchild. Time and again, the article poses Sheila Bair and the FDIC as unsuccessfully trying to thwart Geithner's plans, worrying that they put the taxpayers at too much risk. It's certainly not good for his image that Geithner is repeatedly depicted as standing up for the banks' interests, while other government officials, usually from the FDIC, stand up for the taxpayers (although this does seem to be a fairly accurate description). Might the unnamed "others" in the room have been FDIC officials with an axe to grind, hoping to make their boss Bair look better? Back to the article:

Mr. Geithner has also faced scrutiny over how well taxpayers were served by his handling of another aspect of the bailout: three no-bid contracts the New York Fed awarded to BlackRock, a money management firm, to oversee troubled assets acquired by the bank.

BlackRock was well known to the Fed. Mr. Geithner socialized with Ralph L. Schlosstein, who founded the company and remains a large shareholder, and has dined at his Manhattan home. Peter R. Fisher, who was a senior official at the New York Fed until 2001, is a managing director at BlackRock....

For months, New York Fed officials declined to make public details of the contract, which has become a flash point with some lawmakers who say the Fed’s handling of the bailout is too secretive. New York Fed officials initially said in interviews that they could not disclose the fees because they had agreed with BlackRock to keep them confidential in exchange for a discount.

The contract terms they subsequently disclosed to The New York Times show that the contract is worth at least $71.3 million over three years. While that rate is largely in keeping with comparable fees for such services, analysts say it is hardly discounted.

Translation: Geithner gave lucrative contracts to close acquaintances. Even if this is not a case of clear cut corruption, there is an appearance of impropriety.

The obvious question this article raises is why publish it now? The populist fervor over the AIG bonuses has died down, and the market rebound over the last six weeks has quieted other (read: CNBC and their ilk) critics. Several possibilities jump out:

• FDIC officials are wary of being implicated in the PPIP scheme, and want to separate themselves from Geithner.
• Officials are worried not enough banks are willing to participate in the PPIP since the prices the leverage the government will provide will not be enough to prevent banks from taking large losses, so they want to lay the groundwork for blaming Geithner.
• Administration officials are jockeying for Geithner's job (yes, that means you Larry), and are setting him up as the fall guy once it becomes clear the green shoots are just a blip on our downward trajectory.
• The politicos like Rahm and Axelrod - who already distanced themselves from Geithner when he rolled out the PPIP - are positioning themselves to take a much tougher line on the banks, and need to scapegoat Geithner first (though is it really scapegoating if the blame is justified?). The fact that the article quotes several liberal critics of the bailouts - Stiglitz, Buiter, and Roubini - suggests that their ideas are gaining currency with whoever pushed this story. This would be a very positive development.
  

We can only hope that Geithner is feeling the heat within the administration and that Obama will reconsider whether he wants to tie himself to these unpopular bailouts Geithner has championed. Now if we could just someone besides Summer or Rattner to become Treasury Secretary, we might avoid a lost decade. Would Roubini give up his hard partying ways to take the job?

Our Broken System

Most of the public understands that the legalized bribery known euphemistically as lobbying has to a great extent made our government unresponsive to actual citizens - except, of course, when we demand that members of Congress grandstand against AIG bonuses without actually doing anything substantive. Obama ran against this acceptable corruption in large part, and this line of attack certainly resonated with a sizable segment of the electorate (whether reality matches the rhetoric is another matter entirely). Indeed, we wouldn't need change we can believe in if we didn't think the system was rotten, with inside-dealing and kickbacks being the rule.

Given this, the recent report in the New York Times that a consortium of some of the country's largest companies lobbied Congress against taking action to mitigate global warming despite their own scientists' reports that human activity had unequivocally contributed to global warming should not be shocking. As the Times reports:

For more than a decade the Global Climate Coalition, a group representing industries with profits tied to fossil fuels, led an aggressive lobbying and public relations campaign against the idea that emissions of heat-trapping gases could lead to global warming.

“The role of greenhouse gases in climate change is not well understood,” the coalition said in a scientific “backgrounder” provided to lawmakers and journalists through the early 1990s, adding that “scientists differ” on the issue.

But a document filed in a federal lawsuit demonstrates that even as the coalition worked to sway opinion, its own scientific and technical experts were advising that the science backing the role of greenhouse gases in global warming could not be refuted.

“The scientific basis for the Greenhouse Effect and the potential impact of human emissions of greenhouse gases such as CO2 on climate is well established and cannot be denied,” the experts wrote in an internal report compiled for the coalition in 1995.

The coalition was financed by fees from large corporations and trade groups representing the oil, coal and auto industries, among others. In 1997, the year an international climate agreement that came to be known as the Kyoto Protocol was negotiated, its budget totaled $1.68 million, according to tax records obtained by environmental groups.

Throughout the 1990s, when the coalition conducted a multimillion-dollar advertising campaign challenging the merits of an international agreement, policy makers and pundits were fiercely debating whether humans could dangerously warm the planet.

I am shocked, shocked that oil and automobile companies would misrepresent the science of global warming! And yet on some level this latest revelation is somewhat surprising. This is not cigarette companies lying about smoking causing cancer. This is worse. Much worse. Smoking (mostly) only effects smokers; global warming will effect everyone. That such short-sighted business interests so effectively controlled government policy brings to mind Mancur Olson's theory about how great nations decline: economic interests capture the government, maximizing their own interests at the expense of the common good. This eventually leads to economic stagnation. Is this how a great nation ends? Not with a bang but with a bailout - and tax breaks?

Is There Even Demand For New Debt?

If only we could just get banks lending again, we could go back to those heady pre-Lehman days of credit-fueled consumption growth - that seems to be the rationale animating the Geithner banking plan. If we get these toxic assets - er, I mean "legacy assets" - off of banks' balance sheets, then they'll be sound enough to extend credit again. Economic recovery will follow soon thereafter. But can we return to the status quo ante? Or has the deleveraging process gathered such momentum that even if households could take out new loans, they'd choose not to, as they instead try to pay off their existing onerous debt obligations?

Count James Galbraith among those skeptical that even a successful bank bailout would reverse the economy's death spiral. Rather, restoring household solvency is the key issue. Indeed, in a piece in the Washington Monthly, Galbraith makes the case that until households are made creditworthy again, lending will not resume at anything close to normal levels. Galbraith begins by noting that:

For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years.

Simply put, American households are drowning in debt. As unemployment rises, wages fall, and option ARM mortgage rates reset to higher levels, increasing numbers of households will not be able to service their debts. Furthermore, now that the game of debt musical chairs is over, and many households have by and large lost access to credit, they must save more to pay off their debts. This means less money for consumption. Businesses in turn will face declining profits, necessitating further layoffs and wage cuts. And of course, all of these losses will reverberate on bank balance sheets, since they hold securitized mortgages, credit card debt, auto loans, student loans, etc. And on and on it goes. Throughout this downward spiral, only debt levels do not fall, posing a rising real burden. This is debt deflation - or a "d-process".

Making the banks solvent again is necessary but not sufficient to resume normal credit expansion. If banks remain de facto insolvent, as the credit losses pile up in both the real and financial economies, then the creditworthiness of American households will be irrelevant - there will be no lending. But this is not to say that fixing the financial system will remedy this collapse in credit. If there is a dearth of creditworthy borrowers, or creditworthy borrowers lose their appetite for new debt - either because they want to pay off their old debts or economic uncertainty makes new business investments seem risky - then the soundness of the banks will be irrelevant. In short, credit depends on both lender and borrower. Both must be solvent and willing to extend or accept a loan for normal credit expansion to occur. But this simple point often gets lost in policy discussions about the banking system. Galbraith points out that

In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal....But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank.

The obvious question is whether there is any reason to expect American households to fix their balance sheets in the near future so that they are creditworthy?

Unfortunately, the answer seems to be no. The wealth effect of vanishing stock portfolios and plummeting housing values not only makes households less willing to spend, but it also leaves them with no collateral with which to take out a loan. Indeed, creditworthiness depends on

a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans.

Here, the especially pernicious effect of falling house prices becomes clear. And unhappily, housing prices still have roughly another 20% to fall from their peak just to revert to historic norms, as the following chart shows.

With foreclosures flooding the market, compounding the problem of a housing glut, the chance that housing prices will overshoot on the downside - and possibly stay there for a prolonged period - is very real. Most American households simply will not have the collateral to secure a loan for quite a few years at the least.

There is also the question of "animal spirits" - will creditworthy individuals want to take out loans? Again, the answer seems to be no. The psychology of this crisis has frozen economic activity. As consumer spending has collapsed, there is little incentive to invest in expanding business operations. The future seems so uncertain that people only want to hold cash or liquid assets like Treasuries. Fear rules the scene. A recent New York Times profile of individuals and businesses in Portland, Oregon captures this sentiment well. Writing about the local Portland economy, the New York times reports that

Even banks that are eager to lend find some of their best customers reluctant to extend themselves.

“The problem is trying to get qualified people to borrow,” said Raymond P. Davis, president and chief executive of Umpqua Bank, a regional lender based in Portland....

“The people that want the money don’t deserve it, and the people that deserve it don’t want it,” said John B. Satterberg, president of Community Financial Corporation. “Everybody’s sitting on the fence.”

This is a liquidity trap. The bank-centric economic rescue plans oftentimes lead us to think of a liquidity trap as a supply problem; the banks will not lend because there is no incentive to lend. As Paul Krugman explains

Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase in the monetary base, because the interest rate you get isn’t enough to make it worth bothering.

This could be certainly be true, and perhaps even was true early on in this crisis, but as fear has gripped the real economy, and households scramble to save every penny they can in guaranteed assets - i.e., cash and Treasuries - it seems clear that there is no longer any demand for debt. This situation will likely continue until insolvent households fix their balance sheets, at which point they will be creditworthy again, and already solvent households will stop putting off taking out new loans, as the fear strangling the economy subsides.

What is to be done to hasten recovery? Absent government intervention, the economy will eventually recover, to be sure. As households cut back, saving to pay down their debts, pent up demand builds throughout the economy. Once households reestablish their financial footing, this pent up demand will cause a new credit expansion and virtuous circle of economic growth. As Paul Krugman explains, this is how nineteenth century panics resolved themselves. The problem is that this can take years - or longer. Economic growth can stagnate for decades, as it did between 1873 and 1897, when the economy was in recession more often than not. An economy depressed over the mid-to-long term means lower tax revenues, and consequently likely increased deficits (absent large spending cuts, which would only exacerbate the downturn). Given that deficits will increase even without aggressive action, the case for proactive deficit spending to get us out of this economic slump becomes strong. But what should our priorities be?

Fixing balance sheets. That is the short answer. Banks and households. Doing one without the other is pointless. Regarding the banks, Nouriel Roubini has made a convincing argument that the Geithner plan is appropriate for solvent but illiquid banks, but not for outright insolvent ones. Of course, distinguishing between illiquid and insolvent banks can be quite difficult. But paying insolvent banks for toxic assets will be like AIG bailout fiasco on a grand scale: black holes sucking in taxpayer money across the economy. For truly hopeless banks, FDIC-style receivership and restructuring is the best answer. This means bondholders, who have heretofore not taken any losses, will not be made whole. Taxpayers will still be on the hook for enormous losses, but they will get all of the upside from selling these institutions back to private investors, and the total bill will be less, since bondholders will chip in. This is not, however, a free lunch. It is fraught with risk. Bondholders could panic, and pull their money out of banks. But it is the least bad option at this point. Just like banks, households need financial restructuring as well. This means writing down debts, particularly the principals on underwater mortgages. Roubini has proposed reviving the Depression-era HOLC, with the government buying up mortgages, and then renegotiating the principal owed, not just the interest payments as the Obama Administration has already done.

Aside from restructuring bank and household balance sheets, we must increase the buying power of the middle class to boost aggregate demand. This means creating jobs and strengthening social safety nets. The stimulus bill is a good first step towards putting the unemployed back to work, but the talk of cutting Social Security or Medicare benefits out of a sense of "fiscal discipline" seems dangerously wrongheaded. Again, from Galbraith

The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

We must not confuse reforming the health care system - expanding coverage and lowering costs - with reducing benefits. Stronger safety nets ensure everyone a minimum living standard, and act as automatic stablizers in a downturn. The challenge Obama faces is incorporating the best aspects of the welfare state, without importing the rigidity in the labor markets that European countries face. This is a fundamental pivot away from the deregulatory, private-sector mania of the last thirty years, and instead imagining a system where not just the rich and connected win, but all share in the benefits; where the government does more to reduce economic uncertainty without choking off economic opportunity. It means creating an economy that grows from the bottom up, rather than the top down. Let us hope Obama is sufficiently bold to meet these opportunities.

Kristof Calls for Expert Accountability

A few weeks ago I lamented the disturbing lack of accountability among our political and media elites. For the supposed experts who hyped WMDs in Iraq and the bubble economy of the last decade, there have been precious little consequences. They are mostly still treated as serious commentators - at least by their fellow elites - and seem to feel no sense of chagrin over their manifest errors. Bill Kristol is the poster child for this phenomenon.



Nicholas Kristof at least deserves credit for bringing this issue to the forefront. From the New York Times:

The marketplace of ideas for now doesn’t clear out bad pundits and bad ideas partly because there’s no accountability. We trumpet our successes and ignore failures — or else attempt to explain that the failure doesn’t count because the situation changed or that we were basically right but the timing was off.

For example, I boast about having warned in 2002 and 2003 that Iraq would be a violent mess after we invaded. But I tend to make excuses for my own incorrect forecast in early 2007 that the troop “surge” would fail.

This is obviously but a single column, but raising this issue of the unaccountability of our often wrong experts is a good first step. Of course, this is not to say that if someone makes a bad prediction they should be barred from offering their opinions. Rather, that chronically bad prognosticators - some might say propagandists - should be discredited, and not continued to be treated as Serious People due to the clubby nature of elite media.

Friedman: Toxic Assets Just Need Some Love

Another day, another gem from Thomas Friedman. While Friedman correctly identifies fixing the banking crisis as fundamental to turning the economy around, he seems to have embraced the "toxic assets are not bad; they are simply misunderstood" fallacy. From the New York Times:

we need to get a market going that would bring fair value and clarity to the "toxic assets" crippling the balance sheets of our major banks. This will likely require some degree of government subsidy to private equity groups and hedge funds to get them to make the first bids for these toxic assets by guaranteeing they will not lose.

Who told Friedman this was a good plan? Could it have been...private equity guys and hedge fund managers? And what is "fair value" for the so-called toxic assets? Is it the price at which selling them will make banks solvent? Friedman has adopted the transparently untrue belief that toxic assets still have some fundamental value, but are being artificially depressed because of panic. Unfortunately, our Treasury Secretary seems to believe this as well. But facts are stubborn things. And the facts indicate that toxic assets are worth even less than what pessimists have projected. This is a solvency crisis. Insolvent, too-big-to-fail institutions need to be put into receivership, broken up into smaller pieces, and sold back to private investors. This will pose numerous technical challenges. It is not a free lunch. But it's the most cost effective way to create public trust that the financial system is healthy.

Alan Blinder: Clueless or a Liar

Yves at Naked Capitalism says most of what needs to be said about this Alan Blinder op-ed in the New York Times. But it's worth reiterating just how much Blinder misrepresents the terms of the debate. The most glaring example is when Blinder writes that:

Another argument is that banks’ dodgy assets are hard to value, making it impossible to know how much capital they need — and probably very expensive to provide it. True again. But nationalization doesn’t make these problems disappear.

If the government takes over a bank, the taxpayers tacitly acquire its assets, thereby inheriting all the uncertainties over valuation. And if a bank has negative net worth when it is nationalized, who do you think fills the hole?

This is patently untrue. The entire point of temporary nationalization is that regulators don't have to price toxic assets; they can simply buy the bank, and then split it into good and bad halves. This is why Alan Greenspan came out in favor of putting insolvent banks into receivership. The good half can be sold back to private investors rather quickly. The bad assets can be held indefinitely, and sold to investors, hopefully as the market for them recovers, like was done with the RTC during the S&L crisis. Of course, if these assets really are worthless, as seems likely, then the taxpayers will end up eating the losses. But at least the taxpayers will have gotten the upside from selling the good half of the bank, and we won't have merely subsidized bankers by giving them cash for trash.

Alan Blinder either does not know what he is talking about, or is intellectually dishonest. Which is worse?

Creditanstalt II?

Over the weekend in the New York Times, Liaquat Ahamed sounded the alarm on Europe's potential for catastrophe. Quick version: Eastern Europe borrowed huge sums in foreign currencies from Western European banks; once lending died in September, Eastern European countries found themselves with massive short-term liabilities they could no longer roll over; the exodus of capital from Eastern Europe, in conjunction with massive current accounts deficits, has caused currency crises across the region, raising the real cost of debts; because of difficulties organizing collective action, particulalry on the part of France and Germany, Western Europe has been unable to agree on a bailout of its Eastern neighbors despite the risks Eastern European defaults pose to Western Europe's banks.

Ahamed concludes:

The response of the American government to the financial crisis has been criticized for being too slow and inadequate. But at least we have a federal budget, the national cohesion and the political machinery to get New Yorkers and Midwesterners to pay for the mistakes of homeowners in California and Florida, or to bail out a bank based in North Carolina. There is no such mechanism in Europe. It is going to require leadership of the highest order from officials in Germany and France to persuade their thrifty and prudent taxpayers to bail out foolhardy Austrian banks or Hungarian homeowners.

The Great Depression was largely caused by a failure of intellectual will. In other words, the men in charge simply did not understand how the economy worked. Now, it is the failure of political will that could lead to economic cataclysm. Nowhere is this danger more real than in Europe.

I couldn't agree more.