Together In Harmony

It's a beautiful thing when Paul Krugman and William Kristol agree on something.  Today they both object to the Treasury rescue package - I'll pause so we can savor this bipartisan moment.

Krugman recycles in his column the same fundamental error he posted at his blog on Sunday, which I rebutted here.  In brief, Krugman argues that the fundamental problem facing the financial services sector is a deficiency of capital, which this Treasury plan fails to address.  The quick rebuttal - if a firm has an inappropriately high assets to capital ratio, it is undercapitalized.  The firm (or the financial services sector) can solve this problem by either raising capital *or* by selling assets.  Since the rescue plan involves huge asset sales to the Treasury, the financial services sector will address (if not resolve) their capital inadequacy by reducing their assets and paying off part of their debt.

Krugman seems to half-grasp this - he explains the concept of de-leveraging, but then reaches the bizzare conclusion that de-leveraging won't address the capital problem.  Here we go:

I have a four-step view of the financial crisis:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.”

The Paulson plan calls for the federal government to buy up $700 billion worth of troubled assets, mainly mortgage-backed securities. How does this resolve the crisis?

Well, it might — might — break the vicious circle of deleveraging, step 4 in my capsule description. Even that isn’t clear: the prices of many assets, not just those the Treasury proposes to buy, are under pressure. And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital.

Or rather, it will be crippled by inadequate capital unless the federal government hugely overpays for the assets it buys, giving financial firms — and their stockholders and executives — a giant windfall at taxpayer expense. Did I mention that I’m not happy with this plan?

The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital. And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to — a share in ownership, so that all the gains if the rescue plan works don’t go to the people who made the mess in the first place.

Well, the financial system needs either more capital to support its current asset base, or fewer assets with the present level of capital.  The Treasury plan gets us there by allowing firms to sell assets. 

Now, I am not saying that this rescue will work, or that the Treasury won't overpay for assets, or that no better plan is available, or that the financial services sector will be adequately capitalized after the rescue.  But I am saying that Krugman is flatly wrong in declaring that "The logic of the crisis seems to call for an intervention, not at step 4, but at step 2: the financial system needs more capital." 

The financial system needs either more capital or fewer (and less risky) assets and business activities.  This plan does address that problem by allowing a reduction in risky assets.  Let's at least have reality-based objections to this plan.  And let me grumble that Krugman has clearly back-pedaled from his Sunday post, which was substantially similar but included this howler:

Even without panic asset selling, the financial system would be seriously undercapitalized, causing a credit crunch — and this plan does nothing to address that.

Obviously the plan does something to address that by allowing de-leveraging through assets sales.  Whether it does enough is a matter of conjecture and debate.

In his current column Krugman edited that clause to present his conclusion as an opinion - "And even if the vicious circle is limited, the financial system will still be crippled by inadequate capital" - rather than a theoretical certainty.  So I am making some intellectual headway here.

As to giving the taxpayer a stake in Wall Street's upside - don't we have corporate and personal income taxes?

Kristol is amusing with this:

And I’ve been shocked by the number of (mostly conservative) experts I’ve spoken with who aren’t at all confident that the Bush administration has even the basics right — or who think that the plan, though it looks simple on paper, will prove to be a nightmare in practice.

But will political leaders dare oppose it? Barack Obama called Sunday for more accountability, and I imagine he’ll support the efforts of the Democratic Congressional leadership to try to add to the legislation a host of liberal spending provisions. He probably won’t want to run the risk of actually opposing it, or even of raising big questions and causing significant delay — lest he be attacked for risking the possible meltdown of the global financial system.

Obama will oppose this plan of the conventional wisdom of the Democratic Party coalesces around opposition.  There is nothing in the world or in his track record to suggest he will actually lead on this.

Kristol continues:

What about John McCain? He could play it safe, going along with whatever the Bush administration and the Congress are able to negotiate.

If he wants to be critical, but concludes that Congress has to pass something quickly lest the markets fall apart again, and that he can’t reasonably insist that Congress come up with something fundamentally better, he could propose various amendments insisting on much more accountability and transparency in how Treasury handles this amazing grant of power.

...

Or McCain — more of a gambler than Obama — could take a big risk. While assuring the public and the financial markets that his administration will act forcefully and swiftly to deal with the crisis, he could decide that he must oppose the bailout as the panicked product of a discredited administration, an irresponsible Congress, and a feckless financial establishment, all of which got us into this fine mess.

Critics would charge that in opposing the bailout, in standing against an apparent bipartisan consensus, McCain was being irresponsible.

Or would this be an act of responsibility and courage? 

McCain is more of a gambler.  Personally I have a hard time contemplating financial Armageddon and concluding that risking it is responsible, but... well, yikes. Part of the excitement of John McCain.

MORE:  Sebastian Mallaby, in yesterday's WaPo, gains a step on Krugman by recognizing that reducing assets and raising capital are flip sides of the same coin.  He argues for raising capital.  Well, maybe.  The problem is, financial firm still own billions of Mystery Assets of uncertain but volatile value.  With enough new capital, the volatility of these assets won't imperil the solvency of the firms, but how much capital is that?  Removing the volatility by removing the assets (and putting them with Treasury) has a certain directness.

And surely some of the upside to these bonds is captured by the Treasury in the from of corporate taxes, personal income taxes and the avoidance of a ghastly depression.

Comments

[M. Simon]

JMH,

Within a couple of days of my complaining MP ads came out tying Raines and Johnson to Zero.

Today we have an ad tying Zero to Chicago (how dare they).

So either I moved things or I was in line with the movement.

If you have a short pithy idea I'll pass it on. It has been 5 or 6 days since I said anything so the channel should be open. BTW the last thing I said was a kudos for the Raines ad.

[Pofarmer]

Are those rhetorical questions Clarice?

Congress has been looking pretty ridiculous for a while now. Wexler holding weekly lynchings. 'Pubs discussing energy policy in the dark?

[Sue]

I heard Obama say today that republicans had been in charge for 8 years. I assume he is referring to Bush, because if you do the math, the Senate has been split during these 8 years, about 4-1/2 years each party and democrats have held the house 2 of those 8 years. The last 2, which have proven to be the worst ever, democrats held both houses.

[JM Hanes]

GMax:

I was just pointing out that the Dems stole a march on my proposed slogan for the Republicans to use (Don't Let the Democrats Fool You - Again).

[JM Hanes]

Sue:

Everybody's just trying to blame as much on Bush as they possibly can before they don't have him to kick around any more.

[Sue]

The daughter and s-i-l of someone I know tried to move into an apartment in Dallas. Their credit was not good enough to move into the apartment complexes they were looking at. The next think I knew, they were living in a new home. Credit must have been cleared up right? Well, apparently not since they had their house foreclosed and are living in a dumpy duplex. Apparently they qualified to move into a new home, no money down but couldn't qualify to live in a gated apartment complex. And don't worry about them, though. They qualified for a new car loan. ::sigh::

[Sue]

JMH,

I'm not taking all the blame away from Bush. He had the bully pullpit. He should have been talking and talking and talking since he first brought this up in 2001. But the gigantic portion of this blame belongs on those who opened up no money down mortgages to people who weren't qualified. When we built our house, we put 20% down. That was a lot of money for us to lose if we didn't think we could afford it. Made us careful in what we built. We paid it off without help from the government because the money we would have lost would have been ours. There is a reason why this tried and true method worked so well for years and years.

[Sue]

I know how to spell. I swear. My brain knows but my fingers don't listen.

[Charlie (Colorado)]

JMH, I really don't think it's fair to blame Bush for not bringing it up enough. he mentioned it 17 times in major policy statements. He put it in the State of the union. He put it in the budget. He did have a couple other things going on: the war, a couple little things like that.

Barney Frank, Chris Dodd, Obama, Kerry, all said "nasty Republicans just want to take away poor people's houses." And the Fannie and Freddie lobbyists spent money like water.

[boris]

The question "Who to blame?" will get answered by the MSM: Bush and the Republicans

"Who tried to prevent?" is a better question. Also "Who can you trust?"

[cathyf]

Also, don't forget that the surrendercrats have spent the last 7 years blackmailing Bush over national security. He could fight the democrats with everything he had, or he could fight the islamonazis.

And if you gotta choose one or the other, that WAS the right decision, of course. Worst case Great Depression II is orders of magnitude better than sharia banking.

[M. Simon]

A couple of good videos for those who like to watch and for those who like to blog:

Thirty Missing Reporters

Resurrection

[BobS]

maybe its why we are hearing so little from the left....they know they did it....dont want to make a big fuss about it.......they dont want anyone following the trail to their own pockets

[M. Simon]

BTW what are my goto sites this election season?

JOM, No Quarter, Sara(Pal2Pal), and Uppity Woman.

Half of them are Dem sites. Whooda thunk?

[BobS]

All:

Any JOM threads talking about the U-Tube spots that Ace and Jawa have been onto?

[clarice]

The Hartford Courant is demanding that Dodd leave the Senate. Well, I can add Dodd Out banners to the sharpened pikes leaning against my house.

[sbw]

I heartily re-recommend Firefox-Greasemonkey-Troll_Block_3 to scrub TCO-like belligerence. Even if someone like Cleo changes names regularly, he's disadvantaged because there is no continuity to his message.

Shame. It needn't be that way. To bad their definition of "discuss" is to win at any cost.

[Barney Frank]

Even if someone like Cleo changes names regularly, he's disadvantaged because there is no continuity to his message.

Yeah but before, using my specialized, optimized, mnemonic visual troll blockers, aka my eyeballs, I could just glance at the bottom, see cleo, and skip the dork.
Now I get halfway through a post before I realize 'Mamma's Little Baby Loves Shortenin Bread' is actually our own resident pustule.

[TCO]

CLEO: I won't change my name to avoid ignore lists. (Sometimes use a different nick on sites that have this one taken though.)

Simple Simon: Wealth transfer from savers to speculators will not stop a depression. Allowing speculators to deal with their losses will not cause one. In addition to the current situation, covering bets of speculators will increase moral hazard which based on actions to date is already high. Alowing speculators to take losses will decrease future moral hazard.

All: Arguing about who caused losses by speculators, while covering them misses the point. This is now. We either do the bailouts now or don't. This is the most critical thing to work on right now. And there is no ethical or economic reason to cover financial speculator's losses from taxpayer dollars.

Not that it should matter, but since you all seem to place politics above country, will just mention that trying to argue who caused this is a losing bet politically. The American people have their eyes concentrated on actions in the moment and will judge those more so than dithering about who caused this. Taking a position of having Republicans out in front doing bailouts to cover Democrat-caused losses is s miserable policy politically (as well as bad ethically and economically).

[Semanticleo]

"CLEO: I won't change my name to avoid ignore lists. (Sometimes use a different nick on sites that have this one taken though.)"

You misconscrew my intent.

[Nenicho]

TCO may talk a little naughty at times, but he's smart. We've already given away in bailouts almost 7.5 billion dollars in rebates, ag bill, housing. Has that helped? No, it was just a drop in the bucket. We can't even get Congress to help us by building refineries, drilling for oil building nuke plants etc to get the economy rolling in a favorable direction. The government should cram down the banks a restructuring plan forcing a debt/equity swap. It's no worse than what we're doing now. I'll shut up too. Sorry, but there other ways. And I'll shut up too.

[M. Simon]

TCO,

Consider the $.7 trillion an insurance premium against a $25 to $50 trillion loss.

If it helps you.

If you only look at the cost side of course it is absurd. If you look at the reward side it makes more sense. Not to you of course.

And you may be right it might not be enough. However, if that is the case it won't matter.

[TCO]

Simon: You keep blathering the same socialistic pabalum. The market does not need some intervention to keep it from irrational runs like that. The natural forces of the market will make it drop value when it should drop value and rise when it should. Get out of the way and let the market find it's level. Pouring money into it will do nothing, other than transfer wealth from savers to speculative losers.

[TCO]

Go read some Adam Smith.

[M. Simon]

TCO,

I'm not against a drop in market value.

I think it should happen over a period of a few months. Not 12 hours.

When it happens in 12 hours you get a cascading failure. i.e. crack propagation.

I'm told you were a nuke at one time. You must know about crack propagation. They used to teach it in nuke power school when I went. ('66)

[kim]

Damn the cracks, full speed ahead.
======================

[kim]

Damn the cracks, full speed ahead.
======================

[kim]

Just trying to keep up with TCO on the patois.
===========================

[TCO]

Simon: My background is of no concern to you. And Rickover would have ripped you up the belly for your trite analogies and lack of understanding of fundamentals.

[clarice]

I could have sworn before I pulled myself away from here and went to bed that TCO had angrily flounced out of here promising never to return.
Must have been a nightmare.

[Cecil Turner]

[Look! A submarine surfacing!]

Errr, but it's white . . .

[Are you saying . . .?]

Yep. Hand me that harpoon.

[TCO]

Clarice: Would it be a nightmare, were I to leave you? Dahling?