In which I disagree with Paul Krugman

by John Quiggin on January 21, 2009

As James Surowiecki points out here, my views on what’s entailed in bank nationalisation differ significantly from those of Paul Krugman. [1] Krugman, like quite a few other advocates of nationalisation, has in mind models like the Resolution Trust Corporation and the Swedish nationalizations of the 1990s, where the government took insolvent institutions into temporary public ownership, liquidated the bad assets and returned them to the private sector. These solutions worked well because the global financial system as a whole was solvent and liquid, even though some sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of individual banks, problems on a much bigger scale than have been seen before (even in the leadup to the Great Depression, the financial sector played a smaller role in the economy than in the recent bubble), but to reconstruct a failed global financial system. It’s kind of like rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous). The job is likely to be much slower than the rescues mentioned above, and the institutions that emerge from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for nationalisation. Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

fn1. Krugman is well-known for being right when lots of others have been wrong, so take this into account in assessing the arguments.

{ 25 comments }

1

David Moles 01.21.09 at 8:06 am

I’m not seeing the fundamental difference with Krugman. You both think the banks should be nationalized. I expect Krugman’s opinion of the banks’ current management isn’t a lot higher than yours. You’re arguing that denationalization won’t happen quickly and that it shouldn’t happen till there’s a better regulatory regime in place; I don’t see anything in that piece of Krugman’s to contradict that. What am I missing?

2

MH 01.21.09 at 3:31 pm

“…seems like doing live electrical work while wearing a blindfold and standing in a pool of water.”

It’s probably worse than that because, to extend your metaphor, there are people actively looking for a stick to use to thwack whoever is getting bailed-out. At least I am.

3

roger 01.21.09 at 3:44 pm

I like the way Surowiecki casts the terms of the argument. It is precisely the fact that, contra his Chicago-ish point of view, private enterprise did not do a good job of allocating capital which is the strongest argument in favor of a national bank.

Was the allocation of capital towards financial innovations and away from, say, energy innovations, and towards inflating assets, like homes, and away from infrastructure an accident of the system? I’d argue that it wasn’t. That is, I’d argue that the private enterprise system was caught in a trap in which it couldn’t profitably allocate capital in the most efficient way. The allocation of capital to the housing market was both inefficient and the best solution that the private enterprise system could come up with. Like all bubbles when they pop, the housing bubble is now being seen as one big mistake. It wasn’t – it emerged from a crisis in the system of the Great Moderation as a logical solution to the problems caused by the collapse of the tech bubble. And, in fact, it was entirely rational to bet that rising housing prices would still find a market with a population of homeowners who, in the nineties, seem to shake off the slowdown in the rate of income increases they’d suffered under Reagan and Bush. I believe the standard ratio for buying a house is that its price be three times the yearly income of the household. From what I read, nationwide, in the naughties, that ratio went to 4:1. If you look at the spread, you’ll see that this reflects, exactly, the stagnation of incomes over the last eight years. And that reflects, exactly, the cul de sac in which we sit with a system that has overemphasized free market solutions over the last thirty years.

One doesn’t need to destroy the free market system, which functioned quite well in the sixties and seventies with a more interventionist government. One simply needs to acknowledge the phase of the business cycle we are in. A Hoover/Roosevelt style national Reconstruction Bank, capitalized with the money that is being poured thoughtlessly into the financial services sector, and empowered to aggressively act to loan to and reorganize enterprises, with the power to create synergies among them – for instance, synergy between our energy sector and transportation – is exactly what we need to break the real problem in the economy – stagnant wages and the decaying wealth of the majority of Americans – and Canadians, and British, and Australians, and Germans, etc.

4

geo 01.21.09 at 4:29 pm

rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous)

An economist who can speak with authority about matters electrical is one to whose opinion I am prepared to give respectful attention.

5

Peter G. Klein 01.21.09 at 5:14 pm

John, why do you think the agency problem would be less severe under government ownership? This strikes me as one of the weakest argument for nationalization. Would would be the objective function of the state-appointed agents? What specific mechanisms would the principals (bank regulators, I guess) use to limit managerial discretion? Is there anything in the theoretical or empirical agency literature suggesting this would work?

6

P O'Neill 01.21.09 at 5:14 pm

I thought Surowiecki’s key point was about the scale and scope of what nationalization would entail. As he and others have pointed out previously, fixing up the UK and US banking systems are very different things. In the UK, once you’ve dealt with the top 6 banks, you’ve dealt with the bulk of the system. Not so in the US: it’s huge, and there are many many banks operating in a messy Venn diagram of market segments. Who exactly is going to run them all if you nationalize the entire system? I also think Krugman needs to revisit the role that an excessive faith in Gordon Brown has played in his opinion on the best mode of crisis resolution. He trashed the TARP in favour of Brown-Darling capital injections last October. That latter model is not looking so good right now.

7

Miriam 01.21.09 at 5:17 pm

The problem with nationalization is the dearth of competent people to run complex financial institutions in a more effective way. The people who have the most experience – the current executives and managers – are discredited and the regulatory agencies have been purged of competent people over the last eight years.

8

Righteous Bubba 01.21.09 at 5:47 pm

The problem with nationalization is the dearth of competent people to run complex financial institutions in a more effective way. The people who have the most experience – the current executives and managers – are discredited and the regulatory agencies have been purged of competent people over the last eight years.

I guess I have to assume this means those purged were executed…

Really, though, it’s not as if you have to hire people to created new-fangled instruments, you want people who will abide by the rules. “Don’t be creative” is a fairly clear plan that has kept loads of banks all over the world solvent. Stodginess is a benefit these days.

9

Steve LaBonne 01.21.09 at 6:21 pm

Stodginess is ALWAYS a benefit in banking. It was always supposed to be boring (remember the 3-6-3 rule- pay depositors 3%, lend at 6%, and be on the golf course by 3.) That’s why repealing Glass-Steagall (which put up a wall between boring banks and exciting high finance) was such a bad idea.

10

MH 01.21.09 at 6:30 pm

Laws can be changed at any time. Heads on pikes (metaphorically) are a far better way to encourage stodginess.

11

Righteous Bubba 01.21.09 at 7:03 pm

Stodginess is ALWAYS a benefit in banking.

Indeed. In making a tepid and badly written argument for stodginess I could certainly have gone further. I guess I was a little surprised at the suggestion that there were no competent people available to run banks when it’s my impression that there are plenty of people out there from the industry with free time on their hands: are all of them compromised past the point of employability?

12

John Quiggin 01.21.09 at 7:54 pm

Indeed, banking should be a boring public utility. Talking of which, at one point in my past career, I was (partly) responsible for regulating the electricity distribution industry here in Queensland, which is why the metaphor occurred to me.

13

bartkid 01.21.09 at 8:12 pm

>The problem with nationalization is the dearth of competent people to run complex financial institutions in a more effective way.

To which I say, huzzah.

Step one of nationalization is to pay what the troubled firms are worth (i.e., including the toxic sludge assets, a negative number).
Step two is to fire all management of those firms and any front line staff who can be shown to have committed fraud.
Step three is to break each of the firms into tiny bits, selling off what is profitable and burying unmourned what isn’t. If leveraged buyouts were such glorious capitalist initiatives for junk bondsmen of the 1980s and 1990s, they should be options worthy of consideration today.

If the firms are too big to fail and too big to manage, they are too big to keep around.

14

Sebastian 01.21.09 at 8:41 pm

“The allocation of capital to the housing market was both inefficient and the best solution that the private enterprise system could come up with. Like all bubbles when they pop, the housing bubble is now being seen as one big mistake.”

The problem is that the housing bubble was an enormous private-public partnership in screwing up. The reason why I’m skeptical (not dead-set against or hating or whatever) of the cheerleading for nationalization is because it doesn’t seem to admit the enormous part that government tweaking with incentives had to do with it. Government influence on the lending rates influenced it. Government tax advantages for home ownership influenced it. Government incentives for higher-risk buyers influenced it. Government voicing conerns that much of the classification of ‘high-risk’ was really racial animus (the late 1990s ‘redline’ debates) influenced it.

Now the private market did lots of stupid things too. They sliced and diced so many things that they divorced the risk analysts from the risk takers. They made awful loans. They overestimated their abilities based on a generally positive economic environment.

There were lots of screw ups from the government and the private sphere. But contrary to much popular leftish opinion, many of the government screw-ups were not just a function of Republican administration. (In fact one of the most obvious ones, the Fannie Mae rule changes, was done by Democrats in the face of Republican opposition).

I would tend to argue that political pressures (including many ‘Democratic’ political pressures) overtook good judgment in government just as financial exuberance overtook the private sphere. I would further argue that governments have not proven particularly good at recognizing and popping bubbles. (See for example UK housing bubble anyone?). I would suggest that to the extent that allocation of blame might be less for the government in this case does not necessarily show that government is better, but tmerely hat it was less involved. The areas in which it was involved (interest rates, Fannie Mae, tax benefits for homeownership–and at least two of those are quite Democratic Party oriented) don’t suggest that the government was allocating resources away from the housing bubble in such a way that we should believe that it was making superior decisions.

Which is not a slam dunk argument against government involvement, the private sphere did a crappy job too! I’m just being an actual conservative and being cautious…

15

lemuel pitkin 01.21.09 at 8:42 pm

Indeed, banking should be a boring public utility.

Daniel Davies was arguing strenuously against exactly this view in comments here a couple months ago. Wonder if he’s had a rethink? if not, would be very interesting to see a good intra-CT debate on the subject.

16

roger 01.21.09 at 10:04 pm

Sebastian, the government has “interfered” in the housing market since 1945. The difference with the interference this time is the destructuring of the regulation of mortgages that put in Gramm’s bill on the deregulating the Commondity Futures Market and signed by Clinton in 2000.

But, in essence, that is neither here nor there. In fact, the private sector acted as rationally as it could by pumping money into the housing bubble. In other words, it wasn’t some contingency that caused the private sector to misallocate capital. Nor was it interference from the government – in fact, the degree of government regulation diminished. Rather, the problem was one of structure. The private sector, contra the neo-classical model, doesn’t operate under conditions of full employment, and does operate within a business cycle that determines the investment landscape at any one time. In other words, it was due to the structure of the private sector that capital was allocated suboptimally and inefficiently. The conservative economic policies of the Clinton and Bush administration had retracted the kind of positive interference by the government to give the private sector the fullest possible space to maneuver. And the private sector took advantage of that space – in fact, in 2004, you would find conservative economists or publicists, like Mankiw and Larry Kudlow, bragging about how well it was operating. It was a boom. However, this boom depended on battering the bargaining power of labor so that there was no median rise in household income, while at the same time creating more credit for the median household to use.

The housing bubble, in other words, was the best solution the private sector, under the freest conditions since the 1920s, could come up with.

Now, those conditions are not going to be changed no matter how much money is poured into failing banks and hedge funds. They are only going to be changed by inflating incomes. This will not come about if business and commerce aren’t revived. But there are no sources within the private sector for that revival. Which is why liquidate liquidate liquidate will only lead to ever worse conditions. To revive the economy in this phase of the business cycle, command and control economics, using the power of the state to, for instance, capitalize a Reindustrialization facility, is the best and shortest way.

Again, the argument here isn’t whether the Democrats or the Republicans should have done x or y to regulate Fannie Mae. The argument is that the regulatory environment was the most business-friendly since the twenties, and the Free markets responded by allocating capital in those ideal conditions as the market decided was most efficient – that is, most profitable. it seems to me that you don’t get to test many economic models as well as we get to test the model of free markets lately.

17

dsquared 01.21.09 at 10:07 pm

Daniel Davies was arguing strenuously against exactly this view in comments here a couple months ago

No I wasn’t. I might or might not believe it to be the case, but I wasn’t.

18

Barry 01.22.09 at 2:06 am

Sebastian: “Government voicing conerns that much of the classification of ‘high-risk’ was really racial animus (the late 1990s ‘redline’ debates) influenced it.”

BZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZZT. Your answer was ‘blame the CRA’, which is wrong!

However, thank you for playing ‘right-wingers *always* play the race card’!

19

Walt French 01.22.09 at 2:17 am

I also favor careful inspection of the alternatives, but find it disingenuous to prefer A over B because B has fault Z, while not mentioning the obvious faults of A (and C, too).

It seems we have three choices:
(1) nationalize insolvent banks (maybe, most of them?); have politicized negotiations with debtholders as to how they will be paid off. The Feds absorb the toxic assets at huge expense and the resulting “good bank” is sold off, with previous debtholders likely getting a large share.

(2) have the Treasury and the Fed make huge subsidies to insolvent institutions; any and all comers mostly welcome. Either thru free grants or hugely over-market purchases of toxic and merely tainted assets, the banks are restored to their pre-meltdown health and go about their merry business.

(3) Strictly Libertarian: encourage Messrs. Geithner and Bernanke to take up pipe-smoking, and encourage them how to stroke their chins while murmuring, “hmmmmm.” The US Government could, however, recycle old Greenspan aphorisms about free-markets’ eventual self-corrections.

As a hopelessly WAG, options (1) and (2) cost one to three trillion dollars, and might have a future expense of a like amount due to crowding out other investments over many years. Option (3) costs at most a few thousand dollars in direct cost, but probably results in a few dozen trillion dollars of lost GDP.

It is easy to paint a picture where arm’s-length relations to Management might be hugely better than the uninformed supervision that caused the mess. Yes, it could also be very bad.

It is also very easy to see how the subsidy option is perceived as the biggest involuntary transfer of wealth from the middle class to the wealthy, cause for insurrection, even. The Senate has gone along so far based on a very thin layer of trust that Obama will exact a fair exchange from the “greedy” individuals who caused our troubles, in his words.

If those who oppose nationalization as problematic would choose to explain how options (2) or (3) as superior, I think it would be very helpful.

20

MarkUp 01.22.09 at 4:14 am

”(3) Strictly Libertarian: encourage Messrs. Geithner and Bernanke to take up pipe-smoking, and encourage them how to stroke their chins while murmuring, “hmmmmm.” The US Government could, however, recycle old Greenspan aphorisms about free-markets’ eventual self-corrections.”

On that note, perhaps this is all the fault of anti-smoking regulation; would be interesting to see a graph of the decrease of indoor smoking via regulation to the rise in other risk taking.

21

lemuel pitkin 01.22.09 at 5:19 pm

No I wasn’t. I might or might not believe it to be the case, but I wasn’t.

Well, folks can read the thread for themselves, and decide. But it’s hard to deny that when the view was expressed there that much of the work of financial intermediation that is done, in English-speaking countries, by profit-seeking agents in financial marekts, could instead be done in a rules-based way by public or quasi-public instituions (i.e., by public utilities) you expressed rather strong skepticism that anything like that was possible, at least without an unacceptable cost in slower growth.

And who knows, maybe you were right. That’s why it would be so interesting to see a debate between you and John Q. on the subject.

22

dsquared 01.22.09 at 5:32 pm

You appear to be conflating (both here and in that thread, but it’s a mistake both times) the business of banking with the entire operation of financial markets (particularly, stockbroking). John might believe that equity capital markets also ought to be run as state-managed utilities, but I don’t think he’s said so yet.

23

lemuel pitkin 01.22.09 at 6:00 pm

It seems to me, though, that one of the main lessons (and preconditions) of the current cirisis is precisely the blurring of the line between banking and the broader financial markets, and the generalization of stockbroker-like activity to finance stuff that used to be done in a routine way by banks. Isn’t that what people are talking about when they point to the shift toward an “originate and distribute” model of banking?

In other words, to the extent that banks and capital markets are in the same basic business — intermediating between savers and borrowers — I take John to indeed saying that the latter ought to be run as (or replaced by) public utilities. But perhaps he’ll step in and explain why I’m wrong.

24

J. Greenhalgh 01.24.09 at 9:14 am

No one has addressed the fact that the U.S. financial system is so vast that, in effect, it IS the financial market. If you nationalize the banks and wipe-out shareholders, you also wipe out many of the main players in the eventual re-nationalization. Not to mention the reduction in liquidity this entails (which includes not only fat cigar-smoking capitalists of Nast-cartoon fame, but also pension funds for ordinary americans and middle class individuals with IRAs). As pointed out in someone’s blog here, the RTC and Swedish nationalization took place in the context of a relatively healthy international banking system. Such is not the case today–a critical difference.

25

MQ 01.26.09 at 12:26 am

Who takes the hit for the bad assets? This to me is the more important question. If you nationalize the banks on the basis of paying off all the investors who own the now worthless assets, you’re still talking a historic bailout. If you don’t fully pay off the investors, you’re left with an immensely complex political negotiation about what investors you “save” (pension funds?) and which you don’t.

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