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Could Krugman be wrong?

March 24th, 2009 · 1 Comment

This is actually a case where we hope so, but Brad DeLong, himself a respectable economics professor and Krugman admirer seems to think Krugman is too critical of the Geithner plan.

Why I Think Paul Krugman Is Wrong
by: Brad DeLong March 23, 2009

I find that a scary sentence to write. If the past decade has taught me anything, it has taught me that mistakes are avoided if you follow two rules:

1. Remember that Paul Krugman is right.
2. If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.

So why do I have a positive and Paul a negative view of the Geithner Plan? I see three reasons:

  1. The half empty-half full factor: I see the Geithner Plan as a positive step from where we are. Paul sees it as an embarrassingly inadequate Band-Aid.
  2. Politics: I think Obama has to demonstrate that he has exhausted all other options before he has a prayer of getting Voinovich to vote to close debate on a bank nationalization bill. Paul thinks that the longer Obama delays proposing bank nationalization, the lower its chances become.
  3. I think the private-sector players in financial markets right now are highly risk averse–hence assets are undervalued from the perspective of a society or a government that is less risk averse. Paul judges that assets have low values because they are unlikely to pay out much cash.

One way to think about it is that the privates are placing a low market price on distressed securities because they place a high weight on future scenarios in which the prices of distressed securities fall still further: in such scenarios they will need cash really badly, and the additional losses that would be generated if they further extended their positions and if such scenarios came to pass would be extremely painful–institution-destroying, and hence to be avoided at all costs.

The government, however, is the agent of society at large. As such, it is close to risk neutral: only the losses associated with truly great depressions get substantial extra weight. It doesn’t care much about bad news that leads to further declines in the values of toxic assets it holds: if worse comes to worse, it can always offset them by printing more money and so generating an inflation that is annoying and painful but not something to be avoided at all costs.

It is this difference between the (extremely low) risk tolerance of private financial intermediaries and the (relatively high) risk tolerance of the government and of society at large that creates the rationale for a program like the Geithner Plan.

Tags: Credit Crisis · Public Policy

1 response so far ↓

  • 1 Confusing signs.. — shareholdersunite.com // May 12, 2009 at 4:54 am

    […] in doubt side with Krugman is what fellow economist Brad DeLong has argued. So what does Krugman argue, well, that’s not very encouraging […]