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Monday, October 22, 2007

In Which I Try to Debate Paul Krugman and Alan Greenspan at the same time.

I do have Hank Paulson on my side, but I think I might be right anyway.

Paul Krugman is unimpressed by

the rescue plan proposed by a group of large banks, with Mr. Paulson’s backing.

Right now the bleeding edge of the crisis in confidence involves worries that there may be large losses hidden inside so-called “structured investment vehicles” — basically hedge funds that borrow from the public and invest the proceeds in mortgage-backed securities. The new plan would create a “super-fund,” the Master Liquidity Enhancement Conduit, which would seek to restore confidence by, um, borrowing from the public and investing the proceeds in mortgage-backed securities.

The plan, in other words, looks like an attempt to solve the problem with smoke and mirrors.

One kvetch. To me a "hedge fund" which borrows "from the public" is a contradiction in terms. Hedge funds are not subject to banking regulations, because they don't borrow from the public. IIRC the minimum investment in a hedge fund is $ 100 million which means they borrow only from the really rich public. Generally hedge fund investors are other institutions.

Krugman argues that the problem is that people will default on mortgages and the super fund will simply hide the fact that securities backed by those mortgages are no good by trying to drive up the price. If this is going on, it won't work and, being an effort to hide the problem will reduce confidence in the financial system.

Ah yes I remember that argument. It has often been applied to bank bailouts. The idea is that banks fail because they are insolvent (can't ever pay off their liabilities) and that, given the way savers rationally reason, illiquid banks (which can't pay depositors right now) are usually insolvent. Thus a loan to keep a bank open is just smoke and mirrors as it replaces debt to depositors with debt to the trick scheme that temporarily hides the insolvency of the bank.

That tricky scheme is called the federal reserve system and the head conspirator was for years Alan Greenspan.

Sensible people agree that solvent banks can easily be illiquid because the prophecy that their will be a run on a bank is self fulfilling. Thus a lender of last resort prevents bank failures even if it rarely lends. It's existence is enough to prevent bank runs.

Thus Krugman is essentially arguing that the analogies between “structured investment vehicles” and banks and between their current troubles and bank runs are bogus. Otherwise he would conclude that the federal reserve system is just smoke and mirrors and should be eliminated or he would have to explain what is the difference.

I conclude that Paul Krugman thinks there is no need to respond to the arguments of for people like Paul Krugman.

Either it's like a banking panic or it isn't and I don't need a Clark medal to manage that reasoning.

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