Why Paul Krugman is Wrong

Discussion in 'Wall St. News' started by aresky, Mar 24, 2009.

  1. aresky


    Brad DeLong:

    "So why do I have a positive and Paul a negative view of the Geithner Plan? I see three reasons:

    The half empty-half full factor: I see the Geithner Plan as a positive step from where we are. Paul sees it as an embarrassingly inadequate Band-Aid.

    Politics: I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul thinks that the longer Obama delays proposing bank nationalization, the lower its chances become.

    I think the private-sector players in financial markets right now are highly risk averse--hence assets are undervalued from the perspective of a society or a government that is less risk averse. Paul judges that assets have low values because they are unlikely to pay out much cash.

    One way to think about it is that the privates are placing a low market price on distressed securities because they place a high weight on future scenarios in which the prices of distressed securities fall still further: in such scenarios they will need cash really badly, and the additional losses that would be generated if they further extended their positions and if such scenarios came to pass would be extremely painful--institution-destroying, and hence to be avoided at all costs.

    The government, however, is the agent of society at large. As such, it is close to risk neutral: only the losses associated with truly great depressions get substantial extra weight. It doesn't care much about bad news that leads to further declines in the values of toxic assets it holds: if worse comes to worse, it can always offset them by printing more money and so generating an inflation that is annoying and painful but not something to be avoided at all costs.

    It is this difference between the (extremely low) risk tolerance of private financial intermediaries and the (relatively high) risk tolerance of the government and of society at large that creates the rationale for a program like the Geithner Plan.

  2. aresky


    Mar. 24, 2009, 7:24 AM

    After a global search, we've finally found another smart economist who doesn't hate the Geithner bank plan. In fact, Brad DeLong, actually likes it.


    Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

    A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition...


    Q: Why isn't this just a massive giveaway to yet another set of financiers?

    A: The private managers put in $30 billion and the government puts in $970 billion. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year. In this case, the private managers' returns can be thought of as (a) a share of the portfolio's total return proportional to their 3% contribution, plus (b) a "management incentive fee" of (i) 0% of the capital value and (ii) between 0% (if the portfolio returns 3% per year) and 9% (if the portfolio returns 10% per year)--much less than hedge-fund managers typically charge. the Treasury is only paying 0% of the capital value and 17% of the profits every year.


    Q: So the Treasury is doing this to make money?

    A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.

    Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?

    A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lousy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.

    Q: So?

    A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.

    Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?

    A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.

    Q: Oh.

    A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.

    Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.