Tuesday, March 31, 2009

Two Lingering Questions For Krugman

Nobody has earned the the right to say "I told you so" as honestly as Paul Krugman. Like many others, I have not hidden my gratitude. Yet I wonder about two of his claims against Geithner's plan that seem to me both crucial and not sufficiently answered, at least not in Krugman's writings and public appearances I have seen. If we are going to put major banks into receivership--in effect, nationalize them--the answer to both had better be "no." (I have some working hypotheses, but l am prepared to be enlightened.)

1. The first has to do with the meaning of insolvency, or its flip, the recoverable value of mortgage-backed securities on banks' balance sheets. Krugman insists that Geithner is not acknowledging the size of the housing bubble, that is, the very low actual values of these assets, as compared with the values they were booked at. But these values, much like the price of oil, depend almost entirely on the pace of recovery. What, if anything, can be said about that?

The value of housing will almost certainly not get back to what it was at the height of the bubble--probably not even close. And yet, obviously, mortgage-backed securities are worth something very different in an economy that is contracting as opposed to one that is growing at just 2% a year. In that economy, many fewer households are defaulting on their mortgages, fewer loans are "under-water," and so forth.

Krugman attributes to Geithner a Wall Streetish view that "the bad assets on banks' books are really worth much, much more than anyone is currently willing to pay for them." But might they be worth only "much" more? The issue at hand is how fast do we get to reasonable levels of growth and does the nationalizing of major banks hinder or accelerate recovery.

Krugman, looking at the U.S. in the 1930s, or Japan in the 1990s, has concluded that we will not get back to more normal levels of growth for some time. But what exactly does that mean? If our growth is flat for a decade, as in Japan, then these assets are very, very bad indeed, and tax-payers are suckers for leveraging private equity purchases of them. But if the economy starts turning around in, say, 18 months (partly, but not only, as a result of this temporary leveraging), then the assets are merely bad, and Geithner's plan must be seen as the best under the circumstances.

So the first question is this: Given how much faster financial capital and entrepreneurial information move today than they did in the 1930s, or even in Japan in the 1990s, can we not assume that the pace, not only of decline, but recovery, too, will be much faster than any historical precedent? The president implied that he thought so in his "Sixty Minutes" interview last week, when he spoke of how "wired" the world has become.

2. Krugman suggests that Geithner (Summers, etc.) is a creature of Wall Street. But this begs the question of whether personal loyalty to bankers, or grudging professional respect for them, motivates him and, in any case, should concern us.

Krugman is right (and Geithner agrees) that managers of banks, investment banks, hedge-funds, etc., cashed in on government largesse and incompetence in the past. But in spite of their demonstrable greed, and even herd behavior, is replacing hundreds, perhaps thousands, of senior bank executives with public servants a little like disbanding and de-Ba'athifying Sadaam's army, a morally satisfying but systemically catastrophic thing?

So the second question is this: Do bankers, for all their faults and grotesque enrichment, know some important, subtle things about managing risk, assessing business plans, providing financial services, and so forth that we dare not lose during the process of recovery? Is there not real know-how here, not just know-about (that is, insider stuff, like ways of betting against "AIG's book")?

This is not a completely rhetorical question. I have not spent nearly as much time with the managers of banks and funds as I have with managers of technology companies. I really cannot say whether senior bank executives at Citigroup or Bank of America should be compared with executives at Google or IBM; whether they are really creative and talented people or just glorified salespeople with stunning commissions thanks to the sheer size of deals they have been rolling. And I can see the point of forcing the resignation of some banking CEOs, for the same reason GM's Rick Wagoner had to go.

Still, is running a bank like running, well, Phillip Morris, a job with its own challenges, to be sure, but nothing that smart, experienced managers can't pick up after a few months, and with trivial impact on the economy as a whole? Krugman wants bankers to be "boring" again? But in this same "wired" world, can they ever be boring again? Geithner seems to want to keep the management of banks more or less intact, even as he contemplates regulations that may make them more boring. Is this moderation not more prudent?