History is Happening Now

I desperately wish some big-shot left-wing pundit could explain to me why they are all so certain that the Obama Administration’s bank bailout plan won’t work.

Unfortunately, their attempts to explain themselves are (a) increasingly bizzare, and (b) not persuasive at all.

A classic example of the bizzare, unpersuasive criticism of Obama’s plan came recently from Arianna Huffington in her blog post entitled “The Obama Economic Team’s Flawed Cosmology: Still Believing the Universe Revolves Around the Banks.”

Huffington makes her opinion about the bank bailout perfectly clear: She thinks the bailout bill is based on false assumptions, and if Obama doesn’t alter his approach, it “can only lead to our being lost at sea for years to come.”

But why?

According to Huffington, it’s about “cosmology”:

Talking about our financial crisis with them is like beaming back to the 2nd century and discussing astronomy with Ptolemy. Just as Ptolemy was convinced we live in a geocentric universe — and made the math work to “prove” his flawed theories — Obama’s senior economic team is convinced we live in a bank-centric universe, and keeps offering its versions of “epicycles” and “eccentric circles” to rationalize their approach to the bailout. And because, like Ptolemy, they are really smart, they are really good at rationalizing.

It’s easy to get lost debating the complexity of each new iteration of each new bailout, but the devil here is not in the details — but in the obsolete cosmology.

If you believe the universe is revolving around the earth — when, in fact, it isn’t — all the good intentions in the world, and all the endless nights spent coming up with plans like Tim Geithner’s Public-Private Investment Program will be for naught.

Get it? When it comes to the Obama Administration’s approach to rescuing our financial system, “the devil here is not in the details.” So people like me who want to hear a clear, detailed analysis of why the plan will fail are apparently out of luck — since clear, detailed analysis apparently won’t lead us to that conclusion. The “really smart” economists advising Obama are “really good at rationalizing” and “it’s easy to get lost debating the complexity of each new iteration of each new bailout,” Arianna says — so why bother debating the individual merits of these plans, right? Instead, we should just take a giant step back and consider this idea: that Geithner’s plan to rescue our financial system is fundamentally based on the idea that the entire universe revolves around the earth.

Not literally, of course. Geithner doesn’t actually believe the universe revolves around the earth. But he believes something Arianna thinks is comparably ridiculous — what ”we live in a bank-centric universe.” Again, not literally. We can only assume that by “universe,” Arianna means the economy. So Geithner’s assumption — the laughable idea that’s comparable to believing the sun revolves around the earth — is that the U.S. economy revolves around banks.

Here is one example. Everybody agrees on the paramount importance of freeing up credit for individuals and businesses. In a bank-centric universe, the solution was a bailout plan giving hundreds of billions to banks. It failed because, instead of using the money to make loans, the banks “are keeping it in the bank because their balance sheets had gotten so bad,” as the president himself acknowledged on Jay Leno. As a result, the administration, again according to the president, had to “set up a securitized market for student loans and auto loans outside of the banking system” in order to “get credit flowing again.”

But think of all the time we wasted while the first scheme predictably failed. And how much better off we’d now be if we had provided credit directly through credit unions or small healthy community banks or, as happened during the Depression, through a new entity like the Reconstruction Finance Corporation.

Luckily, there is a plethora of economic Galileos out there who recognize that the old bank-centric cosmology is just plain wrong. But while Joseph Stiglitz, Simon Johnson, Jeffrey Sachs, Nassim Taleb, Niall Ferguson, Paul Krugman, etc. are not being imprisoned for life for their heretical views — they are also not being listened to. Which is really surprising for an administration that has prided itself on a “team of rivals” approach.

In other words, saying Geithner believes we live in a “bank-centric” economy is another way of saying that Geithner believes we’d rather have banks lending money than have the U.S. government lending money. Now, we’ve never lived in a universe that revolves around the earth — but we did live in a universe where most of the credit extended to people and businesses in America came from banks, rather than the federal government. What Geithner’s critics believe is that the universe should change from a “bank-centric” economy to a “government-centric” economy. (Imagine what we’d think of Gallileo if he suggested we should change our universe so the earth revolves around the sun – that’s crazier than anything Ptolemy ever believed.)

This is all very interesting – and quite compelling if you’re looking to exploit the current crisis in order to ram through a government takeover of the country’s banking system. But it doesn’t explain why the “bank-centric” view is fundamentally flawed. And as an economic argument, it is simply bizzare.

To the extent that Arianna makes an argument about the actual merits of Obama plan, the basic claim at the center of her argument is that this is a “solvency” crisis rather than a “liquidity crisis.” In other words, her claim is apparently that the banks aren’t lending because they are insolvent, and they will remain insolvent no matter how much money the government pours into them.

I am in no way suggesting there is anything corrupt about this or any quid pro quo involved. It’s just that in a bank-centric universe, funneling no-strings-attached money to too-big-to-fail banks is the logical thing to do.

So is arguing that the banking crisis is just a liquidity problem rather than an insolvency one, as Geithner continues to do (and if the stress tests come back declaring Citi solvent, it will be high time to start stress testing the stress testers).

Get it? Citibank is “insolvent,” and won’t lend money no matter how many billions of taxpayer dollars are dumped onto its balance sheet. Of course, Geithner is conducting “stress-tests” to determine whether Arianna’s claim is correct — but the stress-test will only be valid if it confirms what Arianna somehow already knows: Citibank is insolvent.

The “details” don’t matter to Arianna. What matters is that (a) the banks are insolvent, and anybody who tells you different is lying or blinded by their obsolete cosmology, and (b) the only non-crazy solution to this problem is a solution that involves the federal government taking over the bank’s role of providing the credit that allows our economy to function. And Geithner and Obama’s other economic advisers are “blinded” by an “obsolete cosmology” because they refuse to acknowledge the truth: that the government must take over our financial system, and any solution short of that is doomed to fail.

I suppose it’s possible that Arianna is correct.

But it’s also possible that Citibank and the other banks aren’t lending because their balance sheets are prohibitively bad — and the banks’ balance sheets are bad because they contain so many of these “toxic assets” that they’re forced to value as worthless because the market is frozen. It’s possible that once these assets are removed from the banks’ balance sheets, the banks will be in a position to lend and will do so.

In other words, it may be possible to get credit flowing again without a government takeover of the financial system.

I know that Arianna and Paul Krugman and a whole host of other left-wing pundits think I’m crazy-like-Ptolemy for thinking the sentence above is right.

But why? I’m not afraid of getting lost in the complexity. I’m not afraid of the details. I want to know. Why won’t Geithner’s bank plan work?

There’s a reason why “Joseph Stiglitz, Simon Johnson, Jeffrey Sachs, Nassim Taleb, Niall Ferguson, Paul Krugman, etc.” aren’t being listened to. That’s because their argument relies more on grand notions of “cosmology” than on clear arguments based on facts and analysis.

If these people want to be listened to more closely, they need to stop insisting that Obama is wrong and start explaining why he is wrong. Otherwise, they will remain trees that fall in the forest but don’t make a sound in the White House.

People who pay attention to New York Times columnist and Nobel Prize-winning economist Paul Krugman are certainly aware that he doesn’t support the Obama Administration’s plan to stabilize our financial system.

Obama and Krugman clearly disagree about what should be done. But what is the disagreement? I’ve been struggling to understand the disagreement — something far too few Krugman fans actually try to do, I suspect. 

The Congressional Oversight Panel’s recent report on the U.S. Treasury Department’s plan to try to rescue our financial system includes a critical section (on page 76), which allows us to clarify the nature of the debate. The section refers to the “toxic assets” that the mainstream media constantly talks about when it describes the reasons for the crisis in our financial system.

The debate over the ultimate effectiveness of efforts designed to utilize market mechanisms to restore the values of impaired assets turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to the market strain. If the liquidity discount is real, public-private sector solutions are not only viable but preferable, as they avoid creating new and unpredictable risks that arise from preemptive government seizure of private interests. It is reasonable to assume that a liquidity discount is impairing these assets, for which there is limited trading. Current prices cannot be fully explained without the liquidity factor. Even in areas of the country where home prices have declined precipitously, the collateral behind mortgage related assets still retains substantial value. In a liquid market, even under-collateralized assets should not be untradable or trading at pennies on the dollar. Prices are being partially subjected to a downward self-reinforcing cycle.

In the view of some, it is this notion of a liquidity discount that supports the potential of future gain for taxpayers and makes transactions under the CAP and the PPIP investments, and not subsidies in the usual sense. This is an issue that will continue to divide observers of Treasury’s actions, and ultimately events will bear out whether this approach will work. The Panel notes that Treasury’s approach may prove to be a viable and successful strategy, and offers historical context and the discussion of alternate approaches in the event that changes to Treasury’s current plans become necessary. The Panel has not reached agreement as to whethera change in strategy is currently needed.

It is important to see how the panel’s analysis differs from the analysis Krugman has offered in his influential column in the New York Times. Consider this oft-quoted column of Krugman’s from March 22:

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

It seems clear that the Obama Administration — along with the entire mainstream media, it seems — believes the banking crisis is a direct result of a rapid decline in the market value of the “toxic assets” on their balance sheets. The Obama Administration believes that these banks would be solvent — or at least close to solvent — were it not for these mortgage based assets, which are considered “toxic” because nobody wants to buy them right now.

The Obama Administration believes these assets will ultimately be worth more than their current market values indicate, and both the panel and Krugman support this idea: The report states, “it is reasonable to assume that a liquidity discount is impairing these assets, for which there is limited trading,” and Krugman states, “yes, troubled assets may be somewhat undervalued.”

So the disagreement between Krugman and Obama isn’t about whether these assets are undervalued. The disagreement is about what our financial system will look like after these assets’ market values are brought in line with their actual worth.

The report touches on this disagreement earlier in the report (on page 11):

This (the Obama Administration’s) diagnosis of the financial crisis is driving the Administration’s aggressive interagency effort to revive credit markets and strengthen the balance sheets of financial institutions through capital injections and the removal of toxic assets. Yet this approach assumes that the decline in asset values and the accompanying drop in net wealth across the country are in large part the products of temporary liquidity discounts due to nonfunctioning markets for these assets and, thus, are reversible once market confidence is restored. While critics of this approach warn against a more fundamental solvency problem plaguing the financial institutions holding onto these toxic assets,10 Treasury and key policymakers in the Administration argue that the recently-passed fiscal stimulus passage, Treasury’s foreclosure mitigation plan, and the public-private program to revive markets for toxic assets will strengthen the fundamental value of these assets.

So the crux of the debate is this: Once the market value of these toxic assets rises to a level that matches what these assets are actually worth, will the banks be solvent enough to start functioning properly? Once these assets are valued properly, will the banks feel comfortable enough about their balance sheets to start lending again? Or will they still be so screwed up that they won’t be able to function, even then?

Which leaves me with three lines of questioning for Krugman — and his supporters: What makes you so sure that the Obama Administration is wrong? What makes you so sure that the banks won’t be in OK shape once they’re no longer burdened by these assets, which are artifically dragging down their balance sheets? After all, the banks were clearly playing an effective role in our economy prior to the bursting of the housing bubble — and every explanation I’ve heard of how we got into this crisis points to these “toxic assets” as the catalyst. You say the plan will “almost surely fail.” But what makes you so sure?

Second, how is Obama “squandering his credibility” in moving forward with this plan, and why will this make future action by Congress less likely? No matter how bad things get, it makes no sense that a Democratic Congress would simply give up on saving the economy. Bank bailouts may be unpopular — but premature bank nationalization would be even more unpopular — and economic catastrophe would be even more unpopular than bank nationalization. By taking strong steps now to solve the crisis without nationalization, Obama is setting himself up to make an effective argument later on that nationalization is necessary.

(Obama would be more successful arguing for bank nationalization if he could point to some evidence to support Krugman’s claim that the banks are insolvent for reasons unrelated to the “toxic” assets. So I ask again: Is there any evidence to suggest the banks wouldn’t be OK if these assets were valued properly? What makes you think they have a “fundamental solvency problem” as the panel puts it?)

Third, why do you call Geithner’s plan “hocus pocus”? The problem with the term “hocus pocus” is that it suggests the Obama Administration isn’t making a good faith effort to rescue our economy, but is instead trying to con us with something that obviously won’t work. Yet, the report states, “the Panel notes that Treasury’s approach may prove to be a viable and successful strategy.”

To complain about how Obama is “squandering his credibility” and then accuse him of “hocus pocus” strikes me as disingenuous. If Krugman believes it is important for Obama to maintain his credibility, then Krugman should be defending Obama’s credibility rather than doing everything he can to undermine it. Krugman knows quite well that most people who read his columns are willing to accept his arguments without fully — or even minimally — understanding them. When Krugman accuses the Obama Administration of “hocus pocus,” he does more to hurt Obama than anyone.