Krugman, Don't Throw the Baby Out with the Bathwater Just Yet

Like many bloggers (and a few distinguished gentlemen in Stockholm), I greatly admire Paul Krugman. When I learned he was awarded the 2008 Nobel memorial prize in economics, that made my week.

However, as a trader and participant in the financial markets, I am increasingly taking issue with his decidedly anti-market stance of late and his terminally negative view of Obama/Summers/Geithner grand plan.

Krugman basically rejects any type of market-based solution to the problem. He views the Geithner plan as a lowly bribe and in his latest New York Times column (The Market Mystique) wonders if:

a market in which buyers have to be bribed to participate can really be described as 'better functioning'.

My problem with this is that it's basically an unhelpful (even destructive) moralistic view of the market and that it forgets that markets have always functioned thanks to what quite a few people would call an immoral sentiment but there you have it, namely greed. Greed and monetary incentives are, for better or for worse, at the heart of market-based capitalism. When you use the ethically-charged term "bribe", your are basically demonizing a key component of well-functioning markets: incentives.

Markets are best studied using an amoral approach, otherwise no rational discussion is possible. When one starts attaching terms such as greed, bribe, theft, fraud etc... to a reasonable discussion on what should be done to solve the financial crisis, reason and moderation are the first things to go. Then ,inevitably, the solutions that come to the surface are of the "throw away the baby with the bathwater" variety i.e. destroy the system and start anew.

Maybe, just maybe, that's exactly what we'll need to do, eventually. But it's way too early and way too dangerous to go that route without having exhausted all the other, less extreme, solutions first. It would also be irresponsible.

I'm familiar with the argument that, if we're going to totally revamp the system eventually, we might as well do it sooner rather than later, that it'll be less costly. The problem with this argument is that we actually don't know how costly a hasty destruction/reconstruction of the current financial system would be, the same way we didn't know how costly letting Lehman go under would be. In Lehman's case, I don't think anyone liked the results. So with the economic system as a whole. To paraphrase Bernanke:

A massive economic crisis is not a good time to tear up the financial system.

Disclosure: no positions in the securities mentioned

Comments

[Chezfrederick:]

Good point... No dogmatic or pure solution would turn the economy around without extreme dislocation... and this is not part of human nature. But Krugman is right in saying that the present approach would extend the duration of the pain... We would all choose medication over a heart transplant given the option. But we cannot expect miracles overnight. Patience and positive attitudes will see us through.

Mar 27 06:51 AM

[Speedspirit:]

Positive thinking is a very strong tool along with hope and prayer all have been proven by science. But what caused this crisis hasnt been resolved, has it. Its like trying to cure cancer while the patient continues to smoke. Good Luck.

Mar 27 07:57 AM

[captainccs:]

>>>But Krugman is right in saying that the present approach would extend the duration of the pain.

Sudden death would end the pain but I don't think that is the result we want. I'm as mad as the next guy about the people who created this mess but if the choice is between punishing them and surviving, we have to survive first. Vengeance is no a good economic policy.

But -- why don't they go after the Naked Short Sellers who cratered Bear Stearns? That was criminal activity.

Mar 27 08:43 AM

[atavist.avatar:]

Krugman is flat out wrong because he is shortsighted in his assessment of the consequences. Consider what happened when Lehman failed and ask what will happen if the USG nationalizes the banks - mass arteriosclerosis in the financial system would result. And the impact of that on the economy would be disastrous.

Mar 27 08:55 AM

[workedlate:]

How can you argue that Krugman is against any market based solution? The government has not allowed a market based solution and this new plan is a complete government based solution. Krugman is not against a market solution. He is saying that this is a government solution where governement is trying to disguise the solution as free market. There is nothing free market about the plan and there is nothing free market about a plan of any kind that government guarantees losses or puts a floor on pricing.

Mar 27 09:01 AM

[ZeroCred:]

workedlate is accurate and the OP is 'slightly' off the mark.

"Krugman basically rejects any type of market-based solution to the problem", is an entirely inaccurate statement and I am not really sure how you arrrived at that conclusion.

There is near nothing free market about PPIF. It is an unadulterated asset bubble reinflation strategy. Did you read the white paper on PPIF or just posted from the hip?

1. The far from market leverage ratio of 6:1 on private capital and 1:1 equity matching by Treasury which then can also be levered resulting in the 93% of cap structure being government dough. Is not excessive leverage the root of this problem.
2. While they have not divulged this information I would be 'surprised' given the FDIC free money spigot to banks that the borrowing rate against junk securities being worse than LIBOR + 50bps.
3. Lastly, Fed is only allowing money managers with $10B AUM to bid on these securities.
4. Dare I mention that these loans are non-recourse.

Krugmans point of kicking the can on the road is dead on. This is a bailout that marketly exceeds measly TARP I.

Mar 27 10:50 AM

[Isam Laroui:]

workedlate and ZeroCred, point well taken. The PPIF is definitely not what you would call a pure market-based solution but it has some of the trappings of a market-based solution.

Nationalization without process on the other hand, which is what Krugman is rooting for, is definitely NOT a market-based solution. As a matter of fact it is the antithesis of a market-based solution.

The sad truth is that there is no good pure market-based solution to our predicament and government intervention is required no matter what. Market fundamentalists can turn red in the face all they want, this is a situation where the market has FAILED.

My point is that a solution where the market is involved, even if cosmetically (which is not the case here, the Geithner solution being more than cosmetic) is better than an all-government, the-market-is-the-enemy type of solution.

And by the way, ZeroCred, yes I am "posting from the hip" and I'm proud of it. Isn't that what blogging is all about, a mixture of spontaneity and outside the box thinking? So I'll take that as a compliment even though you don't agree with what I am saying and conclude I must be wrong. It's all good. Keep it coming!

It you guys want to read some of the most sophisticated thinking (a lot more sophisticated than what I can offer) on the Geithner plan and its merits (or lack thereof), I'll refer you to the Bronte Capital and the Interfluidity blogs (this is not self-promotion, I'm just a fan of these two bloggers).

Mar 27 12:28 PM

[tlsc:]

I agree with your comment on Krugman. He is being quite a myopic. Looking at the behaviour of congress, how can anyone continue to suggest nationalising any bank or any instituition - ridiculous!

Mar 27 12:40 PM

[fredissy:]

No.....throw Krugman out with the bathwater.

Mar 27 01:40 PM

[Long US stockS:]

I agree with your comment on Krugman in the article. He is being quite dogmatic lately ,& has no ideas @ Pains of common individuals- Bank nationalization. Then again, what do you expect from "elite millionaire professor".

Mar 27 01:53 PM

[American in...:]

That is nonsense. Sweden nationalized its largest banks and then later privatised them. It worked very well.


On Mar 27 08:55 AM atavist.avatar wrote:

> Krugman is flat out wrong because he is shortsighted in his assessment
> of the consequences. Consider what happened when Lehman failed and
> ask what will happen if the USG nationalizes the banks - mass arteriosclerosis
> in the financial system would result. And the impact of that on
> the economy would be disastrous.

Mar 27 04:17 PM

[ZeroCred:]

Hehe.

Fair enough Isam and thank you for the articles to comment upon.


On Mar 27 12:28 PM Isam Laroui wrote:

> workedlate and ZeroCred, point well taken. The PPIF is definitely
> not what you would call a pure market-based solution but it has some
> of the trappings of a market-based solution.
>
> Nationalization without process on the other hand, which is what
> Krugman is rooting for, is definitely NOT a market-based solution.
> As a matter of fact it is the antithesis of a market-based solution.
>
>
> The sad truth is that there is no good pure market-based solution
> to our predicament and government intervention is required no matter
> what. Market fundamentalists can turn red in the face all they want,
> this is a situation where the market has FAILED.
>
> My point is that a solution where the market is involved, even if
> cosmetically (which is not the case here, the Geithner solution being
> more than cosmetic) is better than an all-government, the-market-is-the-enemy
> type of solution.
>
> And by the way, ZeroCred, yes I am "posting from the hip" and I'm
> proud of it. Isn't that what blogging is all about, a mixture of
> spontaneity and outside the box thinking? So I'll take that as a
> compliment even though you don't agree with what I am saying and
> conclude I must be wrong. It's all good. Keep it coming!
>
> It you guys want to read some of the most sophisticated thinking
> (a lot more sophisticated than what I can offer) on the Geithner
> plan and its merits (or lack thereof), I'll refer you to the Bronte
> Capital and the Interfluidity blogs (this is not self-promotion,
> I'm just a fan of these two bloggers).

Mar 27 04:20 PM

[Isam Laroui:]

American in Paris says: "That is nonsense. Sweden nationalized its largest banks and then later privatised them. It worked very well. "

You know, we might get there eventually but you must realize that Sweden is 1/100th of the US economy (allow me the approximation). So the wholesale nationalization of the US banking system might or might not work here but whatever your opinion on this, you must admit it would a HUGE gamble. No wonder Geithner et al., a mere two months into their jobs (I know it fells like eons) want to try more, shall we say, measured solutions first and see if they stick.

Mar 27 04:58 PM

[Isam Laroui:]

You're very welcome, ZCred :)

Mar 27 05:19 PM

[jrhcorrea:]

Bribes as «incentives»? This is what they call it in Mexico «mordida». Quintessential to corruption. So this is the way capitalism has to go? Then it's doomed. Better go and take a course with local maffia and evolve in real world. But Chinese are to give us lessons about «incentives» and they will be pitiless in the international area. Geithner and Obama already showed their thread...

Mar 27 10:42 PM

[Isam Laroui:]

workedlate asks: "How can you argue that Krugman is against any market based solution?"

Straight from the horse's mouth, check out this Newsweek article on Krugman:
www.newsweek.com/id/19...

In it, Paul Krugman says, speaking about Larry Summers:
"Larry has more faith in markets. I'm more of an interventionist."

Mar 29 07:44 PM