Krugman Banishes Supply-Siders: Hooray?

Coming out swinging like a heavyweight prizefighter, Paul Krugman lands a series of devastating blows to the glass chins of all those Reagan-loving, Laffer-curving, supply side faith-healing conservative ideologues of the last three decades who elevated a bunch of carnival clown politicians to the heights of sainthood in order to squeeze them all into positions of power and control over America. Krugman proclaims the end of: "Old-fashioned voodoo economics — the belief in tax-cut magic — has been banished from civilized discourse. The supply-side cult has shrunk to the point that it contains only cranks, charlatans, and Republicans."

But the time for rejoicing is not yet upon us as Krugman adds: "But recent news reports suggest that many influential people, including Federal Reserve officials, bank regulators, and, possibly, members of the incoming Obama administration, have become devotees of a new kind of voodoo: the belief that by performing elaborate financial rituals we can keep dead banks walking."

To drive home his point, Krugman conjures up "a hypothetical bank" he decides to call "Gothamgroup, or Gotham for short." Krugman sets the terms of his example by saying that: "On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion." This establishes "Gotham" in Krugman's tale as "a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout."

Then Krugman questions the obvious: "Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?" Krugman dons his 'cap of bailout speculation' and comes up with the following possibility: "Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future. Still, the possibility of such a gift is what’s now supporting Gotham’s stock price."

Such an approach seems overly excessive, so Krugman places his right hand upon his Nobel and decries: "A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners."

Alas, Krugman laments: "The current buzz suggests, however, that policy makers aren’t willing to take either of these approaches. Instead, they’re reportedly gravitating toward a compromise approach: moving toxic waste from private banks’ balance sheets to a publicly owned “bad bank” or “aggregator bank” that would resemble the Resolution Trust Corporation, but without seizing the banks first." Which leads Krugman to explain that: "Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, recently tried to describe how this would work: “The aggregator bank would buy the assets at fair value.” But what does “fair value” mean?" Krugman returns to his fictitious bank and remarks: "In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer."

Krugman suggests that: "Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?"

Krugman cuts to the quick: "What I suspect is that policy makers — possibly without realizing it — are gearing up to attempt a bait-and-switch: a policy that looks like the cleanup of the savings and loans, but in practice amounts to making huge gifts to bank shareholders at taxpayer expense, disguised as “fair value” purchases of toxic assets."

Krugman is confounded and questions the governments actions: "Why go through these contortions? The answer seems to be that Washington remains deathly afraid of the N-word — nationalization. The truth is that Gothamgroup and its sister institutions are already wards of the state, utterly dependent on taxpayer support; but nobody wants to recognize that fact and implement the obvious solution: an explicit, though temporary, government takeover. Hence the popularity of the new voodoo, which claims, as I said, that elaborate financial rituals can reanimate dead banks." This sort of Washingtonian-think approach hits Krugman squarely in the gut with a sharp blow reflective of the power of irrational thought and its incompatability with a useful and forward looking plan for economic recovery that forces a doubled over Krugman to unhappily admit: "Unfortunately, the price of this retreat into superstition may be high. I hope I’m wrong, but I suspect that taxpayers are about to get another raw deal — and that we’re about to get another financial rescue plan that fails to do the job." Lets hope even Nobel winners can be drastically wrong; but from the smell emanating from Wall Street and the olfactory deficency that has overtaken Washington; things aren't looking so swell right now.