Krugman On Lehman By Steve Verdon

For the most part a decent article. No really. I know Krugman usually writes spittle flying, eyes popping and vein bulging articles talking about the evils of the Bush Administration, but this time he stepped away from that, for the most part, and wrote a fairly good article that goes over the situation.

To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.

The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.

The lack of information makes it harder for people to make the correct decisions and in the end this can have large effects on markets. The classic and simple example is the Akerlof lemon model where Akerlof’s simple model of used cars showed how, absent good information, the only market for used cars is with lemons. Now imagine a complex and byzantine financial system, could there be problems with information asymetries that could lead to the marget doing something really…well bad? Sure.

And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: with few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. But the economic effects — a freezing up of credit, a downward spiral in asset values — are the same as those of the great bank runs of the 1930s.

And here’s the thing: The defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.

I don’t think this is that likely and Krugman is perhaps engaging in more than a little hyperbole, maybe a tad hysterical. But this could be a bad thing for the economy. However, as Krugman notes,

Now, policy makers are aware of the risks — before he was given responsibility for saving the world, Ben Bernanke was one of our leading experts on the economics of the Great Depression.

Being well aware of what happened in 1931, what went wrong and what should have been done, but wasn’t is a good thing. Which is sort of amusing in that Krugman has at least partially refuted his hysterics above.

So over the past year the Fed and the Treasury have orchestrated a series of ad hoc rescue plans. Special credit lines with unpronounceable acronyms were made available to nondepository institutions. The Fed and the Treasury brokered a deal that protected Bear’s counterparties — those on the other side of its deals — though not its stockholders. And just last week the Treasury seized control of Fannie Mae and Freddie Mac, the giant government-sponsored mortgage lenders.

But the consequences of those rescues are making officials nervous. For one thing, they’re taking big risks with taxpayer money. For example, today much of the Fed’s portfolio is tied up in loans backed by dubious collateral. Also, officials are worried that their rescue efforts will encourage even more risky behavior in the future. After all, it’s starting to look as if the rule is heads you win, tails the taxpayers lose.

There is alot to be said for the problem of moral hazard that comes from continually bailing out financial institutions that fail due to stupid decision making. And the story here is somewhat interesting: the Bear Stearns and Freddie Mac/Fannie Mae bailouts were to give the market participants time to evaluate their risk exposure and take the appropriate actions.

However, there is another potential problem that market participants expect a bailout and hence don’t take the appropriate actions. Afterall if ther is a bailout then the downside is limited, and if there is no need for a bailout-i.e. Lehman finds a buyer and the market bounces back the payoff could be good.

But Henry Paulson, the Treasury secretary, was adamant that he wouldn’t sweeten the deal by putting more public funds on the line. Many people thought he was bluffing. I was all ready to start today’s column, “When life hands you Lehman, make Lehman aid.” But there was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.

I think either way it is the right move. If it is “foolish” to use Krugman’s terms then it is as I noted above, people were expecting a bailout and didn’t get it. This, in the longer run, is a good thing. It tells financial institutions, “Look, you can’t just treat this like monopoly money. If you screw up it is going to hurt, both you, your employees, and others as well, so get your heads out of your butts.” Continiously bailing these institutions out creates a situation that Krugman has outline, heads I win, tails the taxpayer loses. Great gig if you can get it.

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system — if institutions need to be rescued like banks, they should be regulated like banks — why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for “orderly liquidation” of failing investment banks. Well, that was six months ago. Where’s the mechanism?

And here Krugman turns into some pie-in-the-sky type. Really? Six months? Please. Government is slow, cumbrsome, and prone to responding in a clumsy ham fisted manner. This is something that is actually going to take an act of Congress. And guaranteed if government did something fast it would very likely be as bad as doing nothing perhaps even worse.

And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.

And here is the problem with Krugman: you can’t win with him. You really are damned if you do and damned if you don’t. With Krugman he always has his cake and eats it too. Okay, so about the first half to two-thirds fo the article was decent.

This content was used with the permission of Outside the Beltway.

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