• Reading Krugman

    This post originally appeared on The Finance Buff.

    I think Paul Krugman has a blind spot. Yes, the Nobel Prize winning, Princeton University economist, and NY Times columnist Paul Krugman. I saw evidence of it in last week’s debate among economists over Treasury Secretary Geithner’s bank rescue plan, the so-called Public-Private Investment Program (PPIP).

    In brief, under PPIP private investors would receive non-recourse federal loans to buy toxic assets from banks. The goal is to increase lending so as to reduce unemployment. (Was that too brief? If so, the dots are connected in Brad DeLong’s clever FAQ, and well-crafted numerical examples can be found here and here.)

    The cynical won’t be surprised that the plan is similar to one pitched to the Treasury Department by institutional investors, or that some banks may be gaming the system. The plan is also similar to one proposed by Harvard Law Professor Lucian Bebchuk.

    While the White House press corps was not terribly interested in PPIP, it lit up the economics blogosphere. MIT’s Ricardo Caballero thinks the plan “is well-conceived and deserves to be supported.” Johns Hopkins economics professor Christopher Carroll finds savvy the way it induces private investors to price assets. NYU’s Nouriel Roubini is cautiously optimistic. Many other sharp economists view the approach favorably, including Mark Thoma (Univ. of Oregon) and Brad DeLong (Berkeley).

    There is a list of equally impressive opponents. Jeffrey Sachs of Columbia University thinks PPIP provides a one-way bet: heads investors win, tails the government loses. Financial Times columnist Martin Wolf calls PPIP a “vulture fund relief scheme.” MIT Sloan School’s Simon Johnson worries in a well thought out LA Times opinion piece that without nationalization banks will not sell enough of their toxic assets.

    Finally, Paul Krugman is filled with despair over PPIP, calling it a “waste of taxpayer money.” He believes Obama is “squandering [the] credibility” he needs to win support for bank nationalization. (Krugman once worried that nationalization might be too expensive: Times change and opinions with them.)

    As the liberal economist of record, Krugman’s critique of PPIP received a lot of press much of it uncritical. I think a little more critical reading is warranted, that his cry for nationalization now misses something crucial. Namely, he has a blind spot for the political and implementation risks and challenges. As John Heilemann wrote in New York Magazine, “Getting the economics right may be devilishly difficult—but the politics are even trickier, and just as crucial.”

    One cannot be president and apolitical. Incentives and risks of governance compel Obama to think beyond economics even when considering economic issues. He is, no doubt, sensitive to his political capital, the issues over which to allocate it, and Congress’ appetite for alternatives to PPIP (like nationalization), among others. Brad DeLong points out that Obama does not easily achieve the 60 votes in the Senate he would need to take bolder action. (PPIP requires no additional congressional approval.) “Do we want to revive our economy, or do we want to punish the bankers?” DeLong asks, “I don’t agree that we can do both.” Matthew Yglesias elaborates,

    “Doing something…without an additional vote makes it more likely that they can ask Congress to cast those tough votes on the budget and on health care rather than on bank bailouts.”

    According to Obama aides, “Krugman’s suggestion that the government could take over the banking system is deeply impractical.” (Newsweek) Impractical politically but also because nationalization would require expertise and staff the Treasury Department does not yet possess. Therefore, like it or not, Geithner needs the banking industry’s cooperation to increase lending. He nearly lost it during the uproar over the AIG bonuses. He’d lose it for sure with a nationalization plan.

    If nationalizing banks is a political non-starter then attempting to do so would destroy the credibility Krugman feels Obama is squandering with PPIP. Therefore, right now PPIP may be the only step forward. After all, a bank balance sheet has only two sides: assets and liabilities. Nationalization works the latter, PPIP the former.

    My critique of Krugman is brash. He has a Nobel Prize while I have a Certificate of Appreciation from my employer. Yet it is hardly ever wise to consider an expert’s opinion thoughtlessly. Even experts can be poor sources of expertise. Even Nobel laureates make mistakes (like this or this). Whether you’re reading Krugman or TIE, it is not wise to reflexively trust what you read. You can take that to the bank.

    • The problem with your argument is that it requires us to grant you the sort of confidence-in-expertise that you warn against in what is a fairly gratuitous final paragraph. Taking on Krugman is no sin, but slipping in the “you shouldn’t believe him just because he is really, really smart” argument at the end takes us right to the question of your own political chops – What do you know about politics that Krugman does not?

      Note, by the way, that the Kristof piece refers to Tetlok on policy expertise, but is mostly about the fallibility of political “experts”. What you are arguing is essentially your greater understanding of the politics of bail-out. That is an odd argument to try and support by linking to evidence that nobody’s political smarts are all that smart.

    • kharris-

      You make my point well. That’s what I’m saying. It’s a complex world. Yet folks “at the top” of their profession (Obama, Krugman, and others) really do know something about something. They just don’t know everything about everything. But mostly they’re reacting to different sets of incentives. Ignoring those incentives, as Krugman had, leads to impractical recommendations. At least acknowledging the incentives is far more honest and balanced, in my view.

      The politics and practicalities may well align with Krugman’s view in time. I’m betting we can judge whether or not nationalization is going to happen by summer. But don’t trust me. I’m no expert.


    • At no time has Paul Krugman ever promoted “taking over the banking system”. That grossly misrepresents his position.

      In fact, Krugman criticized Pres. Obama’s statement that we can’t follow Sweden’s example “because Sweden only had five banks” by saying “We only need to nationalize four banks.”

      Because the public-private toxic buyout plan does not target just those banks, it is extremely inefficient, giving away taxpayer dollars to billionaires at hedge funds and to solvent banks with only a fraction even going to the banks that are (don’t say this in public) insolvent.

    • Thanks for taking the time to respond. I think there may be another level to the analysis of which economists favor/don’t favor nationalization.

      You mention Professor DeLong as being on the other side of Professor Krugman, but, reading his posts, I think he is only saying that he thinks this plan has a chance of working, -not- that it is a better economic plan than nationalization. I believe he feels nationalization is the best alternative, were it possible.

      Professor Roubini has also been saying consistently, for some time now, that nationalizing insolvent banks is the solution – (http://www.washingtonpost.com/wp-dyn/content/story/2009/02/12/ST2009021203365.html and – are two examples and there are many more. I would say that his economic analysis sides with Professor Krugman, as do the significant majority of “well-known” (at least to me!) economists.

    • My paper “The Put Problem with Toxic Assets” at http://ssrn.com/abstract=1343625 argues that the toxic asset sales (in this case via the PPIP) are most likely to occur between private investors and banks that are not at all close to insolvency. Thus, the PPIP subsidies will go to banks that do not need to sell their toxic assets. http://www.linuswilson.com

    • While Krugman does not talk about the politics of the situation as much as he might, I think his point is different. His point is that what the Obama administration is doing is leading us down the path of Japan’s lost decade.

      The fact that other steps might be politically difficult or impossible hardly affects the validity of that argument.

      If the PPIP does some good and no harm, then we’re fine. But Krugman thinks inaction does more than “no harm”–we don’t have the luxury of trying one thing than another for the next two years. We must _stomp_ on the problem right now. Krugman’s point is that politics or not, by not doing more right now we are damning the country to a lost decade.

      I agree with you that Obama is making political calculations. I even think if I have to choose (and apparently we do) between fixing the banks and national health care, I will choose, as Obama apparently has, health care first. It will do more good long term. If Obama can get national health care and energy independence, I think a lost decade might be worth the price.

      The real problem with the administration right now, and I think Krugman and many others have talked about this, is that they are not being honest with us. He should tell us that is the choice rather than continuing to pretend the banks can be fixed with more small measures. (But that too is surely a political choice–they think, right or wrong, that we are better off not knowing the “truth” while they try to slip the really hard decisions past us.)

    • No, no, no. Pulling out the old “you are making my point for me” thing just won’t do.

      The problem is that you have flatly declared that Krugman has missed the politics of the situation, when what he has done is read the politics differently than you have. In your response to my comment, you have stooped to “At least acknowledging the incentives is far more honest and balanced, in my view.” Honest? This is the Donald Luskin treatment. Again, Krugman hasn’t ignored incentives. He disagrees with you about what they imply as to the best course of action.

      I have never been here before, having come by way of Economists View. My first impression is that you wanna play with the big kids, act as if you have something to add, but you have gone the easy route — The other guy must be wrong when he reaches a different conclusion than your own. If he’s wrong in his conclusion, then you have to attribute motives and thought processes to him to explain how he ended up in so wrong a place. — Stop it. Krugman has addressed politics and incentives and come to a different conclusion than you have. It is – since you raised the point of honesty – dishonest to state, imply, suggest, intimate or hint otherwise.

      Krugman may blow up on this one. Very likely, we will never know because his views won’t be tested. But a critique of the sort that you mount here does us no good in trying to guess whether his views are the right ones.

    • Only a few American institutions were playing the hedge fund game. For example, as far as we know so far, only AIG, among the giant insurance companies, transformed itself into a giant hedge fund. Now other insurance companies are complaining that AIG, flushed with government money, is undermining them by proposing cheaper products, thanks to government subsidies.

      In any case to get lending restarted, it’s enough to get a few giant banks recapitalized. Four banks are most of the problem in the USA (as Obama observed belatedly, having read the good blogs, apparently, they hold 70% of the US market). Sweden had a big problem with three big banks, and gave them an ultimatum: recapitalize, or be seized, and recapitalized by the government (aka “nationalization”). One of the three banks scrambled, and was able to find private finds (some overseas). The other two were nationalized (very successfully).

      The blogger who criticized Krugman above follows Obama’s first rejection of the concept of nationalization. That Obama counterargument consisted in pretending that all American banks, thousands of them, were broke, so nothing could be done, except, as Summers-Geithner suggested, by sending them lots of money to their bosses everyday. This is actually a cover-up for the few banks that broke massively the international capital requirements, by claiming they all did.

      At some point in a public debate, a disconnect often appears between those who understand a problem best and common wisdom, which persists to repeat the same errors. I experienced this recently by having comments blocked (not on this Krugman blog), because I evoked past connections between the National Socialist regime and Wall Street (which are a matter of historical record). This is something common wisdom feels that one is not supposed to say.

      Similarly one is not supposed to say that a relatively small people and institutions have created the present problem. This silence allows their perverse influence to keep on going.

      The Obama administration should concentrate on finding out which big banks, maybe just one or two of them, should be seized and temporarily nationalized. Hedge funds, the very principle of having hedge funds, should be reduced to the original aim of hedging: to balance risks taken by commercial operators. Indeed, immense leveraging in finance has been self serving (see the bonuses, and extravagant compensations). But finance produces nothing per se. Thus finance has hogged the credit that the rest of the planet desperately needs for real industry, to provide jobs, and save a severely compromised planet.

      Patrice Ayme

    • kharris-

      I like Krugman. Yet, he himself has said he isn’t well suited for politics. There’s a reason for that. Not his thing. Nothing wrong with that.


    • Which doesn’t respond to my point about the badness of your argument one little bit. Whatever merits and weaknesses Krugman may have, no matter who is onto the write analysis here, your post is rotten. Wiggle all you want, but you wandered from the strawman thing to the Luskin thing and now to the misdirection thing.

      About the misdirection thing. It rather misses the point to cite Krugman’s views of his own political skills. Again, you have linked (favorably, I take it) to evidence that people who think pretty highly of their own political skills are rotten prognosticators. We know absolutely nothing about Krugman’s ability to read politics from his statements about that ability. It also matters not one bit that Krugman says he doesn’t have political chops if he – and you – are going to go ahead and make political arguments.

    • TIE,

      Thank you for contributing significantly to the debate. You write:-

      “Impractical politically but also because nationalization would require expertise and staff the Treasury Department does not yet possess.”

      This is the area where I would like to see more in-depth analysis (from someone, not necessarily leaving this at your door). I would like to see some more detail in terms of what sort of expertise and staff would be required to temporarily take over an instituition like Citibank. Similarly, there have been vague allusions (not from you) about the systemic risks from nationalization, but no accompanying detail that I can find.

      I wonder whether detailed analysis of these “what if” scenarios might make them politically more palatable.

      Finally (and perhaps this is too idealistic), when Obama is elected on a platform of “change in Washington”, that IMO should mean fighting the political influences when they run contrary to the best course of action for the nation. I believe, like (because of?) Professor Krugman that temporarily nationalizing the banks is the best (not to mention fairest) course of action at this point.

    • Jonathan Dean-

      You raise points of interest for me too. I have not been satisfied by what has been written about the implications of the vacant Treasury positions. Perhaps I haven’t looked hard enough. (If anyone can point to some more in-depth analysis on this, that would be welcome.)

      I honestly don’t know what to believe about which course is best. Well-credentialed economists have taken varying positions. If nationalization is required we will ultimately know it. The fear is that it will be too late and/or politically impossible. We shall see.

      I’m intrigued about the idea of nationalizing the few big banks with sufficiently big problems. Isn’t there a worry about a domino effect, that if you move in on just a few, the next will start to crumble?

      In any case, perhaps even taking over a few really big bank would be too much for Treasury. This gets back to wanting to know more about the implications for vacancies there…

    • Jonathan Dean-

      I don’t entirely disagree with your reading of things. One can be quite nuanced in one’s opinion. In fact, I’m not sure if I hope PPIP works or not. I’m very worried about the long-term implications for moral hazard. Will Geithner’s proposed regulations sufficiently protect us from that?

    • Maybe I’m a simpleton – I would like to see some people go to jail instead of getting rewarded. Seems like the right to a speedy trial by your peers has gone the way of the Dodo bird.

    • You correctly state that Krugman thought nationalization would be too expensive, however, in his estimate, it would cost $850 billion, much less than what is being spent on bank bailouts.

    • My problem with this type of analysis — and I’ve heard it applied by many others against Krugman, and to Obama, Kerry, Gore, etc etc etc all down the line — is that we don’t send politicians to Washington to hoard “credibility” and political capital. We send them there to spend it, by doing Important Things. What exactly would Obama be conserving political capital for, if not this emergency? Isn’t this among the most important issues to hit the country in many decades? The way one accrues political credibility is to fight for just causes. Whereas one can lose political credibility in many ways, including inaction in the face of a crisis. A politician is my employee, and the last thing I want is for him to come home at the end of the day and say “I didn’t dare push for your cause because the wags on Capitol Hill never would have stood for it.” That’s what you’re talking about when you talk about preserving “credibility”. That’s the reason why American foreign policy, for example, has been stuck in the same quagmire for ten or fifteen years or more… “credibility” is too often code for “aping the popular kids”. It has little to do with what’s actually right.

    • Krugman has already responded, but let me refine his point further- why do people always equate “nationalizing insolvent banks” with “nationalizing the banking industry”…? Why do people constantly lie about this? Are people too stupid to figure out that when a “normal” bank is insolvent, we already have a system in place to “nationalize” it? (Hint: it involves the FDIC). Or is it because people fear the political reaction to putting some of our largest banks into receivership?

      If the argument against putting insolvent banks into receivership is a *political* argument, then fine…Make.That.Argument. Don’t pretend that there’s some sort of economic justification for what is essentially a political action.

      Just make the argument that you really believe in. Everything else is just dishonest, on some level or another.

    • I feel like I’m “missing” something in this critique.

      The fact that Paul’s conclusion may not be “practical”, “politically speaking” hardly seems a devastating indictment, given how relative those terms are, at a minimum.

      What is paramount is whether his assessment and prescription are accurate and optimal. The politics of it _should be_ separated, analytically.

      If his general prescription is subordinated to ‘sub-optimal’ “politiking” of the day, that’s a whole other Oprah, yes?

    • Even if the best option cannot currently get by the Republicans, it can still be very valuable to tell the public, especially opinion leaders, that it is best and why, to teach, and to build support for it for now and in the future.

      Also, it may not be that politically infeasible. Here is the comment I left on Krugman’s blog regarding this:

      With regard to the political obstacles, I’m not sure how familiar you are with the filibuster rules, but it may be possible to pass many things with only 50 votes. For example, for another round of stimulus all of the government spending could be put in a reconciliation bill, with tax increases so that it’s revenue neutral. Such a bill cannot be filibustered. Then, a separate bill of tax cuts can be put forward. This will take 60 votes, but it will be very hard for the Republicans to vote against it.

      If Obama is willing to fight, there are parliamentary tactics he can use to force through many strong measures with only 50 votes.

      For more on this see:

    • TIE said:
      “I’m intrigued about the idea of nationalizing the few big banks with sufficiently big problems. Isn’t there a worry about a domino effect, that if you move in on just a few, the next will start to crumble?”

      No, not that I’m aware of. I haven’t heard Geithner or anyone make a domino argument. Further, there is precedent for large players filing actually relieving strains on the market. Anytime you have a clear resolution of a problem, for better or worse, the market will be able to resume functioning with that new data. It’s the uncertainty that freezes markets, not the risk.

      Drexel Burnham and LTCM are the most recent examples I can think of.

    • Great to read someone who references so many other economic thinkers. You gave me a list to follow. I’ve only been reading LaRouche and Krugman who gave ref. to your site. I really appreciate the work you have done. John D

    • Check Krugman’s response to your criticism. Wouldn’t you care to respond back to that?

    • – Mr. Linus Wilson,

      I did go check your paper as the brief summary of your conclusion (posted here on the 2nd of April) resembled my intuitive opinion about PPIP.
      By using the (very) standard corporate finance formulas, I found your paper lost its appeal: Although the fundamental message (subsidies going to unsecured creditors) might not be totally false in the the strict sense, reading this paper made me wonder what you were actually trying to achieve. Just like a Sudoku, your paper looked like an unchallenging, mechanical little exercise to pass time. Your numbered example certainly did not help your case. If you only wanted to reiterate the essence of such basic pricing concepts as the put-call parity and B-S-M option pricing, you could have said that in less than 50 words. I tried, it works. There is absolutely nothing creative in your paper, I am sorry to say. And, to be honest, its prediction / analysis probably isn´t even accurate in today´s situation.
      By staying focused on a rigid, academic view of the world, you mix things that should absolutely be differentiated, especially in today´s world. You talk of banking stocks as if they were rationally priced, based on classical corporate finance theory. You use the concept of volatility in the classical sense, although there is a big difference between volatility as an input in the BSM formula and today´s uncertainty in fair value of mortgage related securities. Do you believe that anyone would ever think of pricing today´s toxic CDOs and ABSs based on their historic volatility? And now which volatility would that be, given that there exists no real market anymore (since 08/07 at least) and that all the fundamental variables have changed? Also, do you believe that any investor out there is actually looking for a long-shot volatility miracle that would spike up the price of toxic assets back to 80cents to the dollar? And of course, who cares about the systemic effects of trying to unclog lending facilities, right?
      Seriously, Mr. Wilson, I do not know what you were trying to achieve with your paper. It would have been a nice, entertaining example to use in a freshman classroom. But please, do you really think you have given any type of intelligent contribution to the discussion by writing this paper? If the put-call parity were a valid argument in today´s discussion about a potentially world-changing rescue plan, do you really think nobody would have thought about it?

      And please, rest assured: Every economic commentator knows that in the wonderful theoretical world of corporate finance, the shareholders hold a put with strike = face value of debt. The only reason why nobody has mentioned it is pretty obvious, Mr. Wilson.

    • kharris,

      With all due respect I think you’re misreading my post. I cite several other authors (including an economist) who suggest that Krugman has ignored the politics. This is my point. I am not suggesting my read of the politics differs from his. I’m suggesting he hasn’t even considered the politics. He has a blind spot.

      Should you believe me? Do I know something Krugman doesn’t? That’s not for me to decide. I’ve expressed my opinion and linked to that of others, both those that support mine and those that do not. You can read all you like, make your own judgement, and write your own blog. Let me know when you do. I’ll read it.