Sat Mar 21st, 2009 at 11:39:58 AM EST
On Krugman's blog today: Despair over financial policy
The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.
As he wrote nearly three weeks ago:
And the insistence on offering the same plan over and over again, with only cosmetic changes, is itself deeply disturbing. Does Treasury not realize that all these proposals amount to the same thing? Or does it realize that, but hope that the rest of us won’t notice? That is, are they stupid, or do they think we’re stupid?
I don’t know which possibility is worse.
There is a third possibility: they are neoclassical economists, they drank the kool-aid of "a decade of financial innovation", or "finance is the brain of the economy", and want to restore the economy to the way it was in 2006, with subprime lending and securitisation and CDOs and CDSs. On this, see (linked to by Krugman) Tim Duy's When Does Faith in Financial Engineering Wane?
(March 3, 2009)
But Bernanke has not given up hope, audacious though it may seem, that the answer is financial engineering. Yves Smith noted last week:
...What is amazing is the degree to which Bernanke has been unable to process what has happened over the last year and a half. It isn't simply that he is trying to restore status quo ante; he seems to see the only possible operative paradigm as the status quo ante. Worse, he has a romanticized view of it too.Leaving aside those challenges, another problem is the one to which Yves alludes to - the persistent belief that current asset prices are currently "wrong." There appears to be little thought given to the likelihood that past prices were "wrong." Instead, policymakers appear to believe that prices have intrinsic values. The trick is to get market participants to recognize those values. The belief (delusion) that the current price is simply wrong is not limited to Bernanke; it is pervasive among policymakers. James Kwak directs us to an interview with Treasury Secretary Timothy Geithner, commenting:
The idea that houses have a “basic inherent economic value” other than the prices they can fetch in the housing market is, I think, a fallacy. And so the idea that therefore houses will naturally return to some “basic inherent economic value” that is higher than current market prices is, I think, wishful thinking of the kind that has hampered responses to this crisis from the beginning. They could; but they could just as well not.
I have to say I find Geithner rather sensible here when he says asset prices need not be higher than they are now. Back to Tim Duy:
And therein lays the key to predicting when the Fed shifts gears; when Bernanke abandons the notion that proper credit market functioning is alone sufficient to restore housing values (asset values more generally) to their former glory and support acceptable growth. At that point, the Fed will again consider the wisdom of what it has defined as quantitative easing, an expansion of the balance sheet via a deliberate expansion of liabilities. Until then, we can expect the Fed to continue its focus on financial engineering.
Oops, I think we're screwed. And don't think European policymakers sound any better. Here's Joaquín Almunia, European Commissioner for Economic and Moneraty Policy, speaking at the end of February
A broad consensus is now forming in Europe that we will need to move fast and introduce some form of asset relief to complement the measures already in place. Many countries are now looking seriously at the options on the table. Some are considering the possibility of setting up a 'bad bank' to absorb the impaired assets, others an insurance scheme.
Asset relief? You mean relieving the bad banks of their bad assets, for free?
However, less important than the model that each Member State chooses, is the fact that all programs should abide by a set of common principles. This is crucially important to ensure that we maintain a level playing field among banks.
Almunia, as Economic Policy Commisioner, doesn't much care what the economic policy is, as long as it preserves a "level playing field".
For this reason, today we are publishing guidelines on asset relief produced by the ECB and the Commission. These set a clear framework for assessing which assets are eligible for treatment and for their valuation. The Commission has tried to adopt a flexible approach in order to be able to cope with the different situations across Member States. This means that action should not necessarily be limited to subprime related assets but could also cover more typical affected by the current economic difficulties.
We also advise Member States on how to value impaired assets. This is a difficult task, especially when dealing with complex financial instruments. The general principle is that in the absence of correctly functioning markets, the valuation of the assets should be carried out with reference to their real economic value. The Commission will promote ex ante coordination of valuation methodologies where possible and establish an independent ex-post review in order to help evaluate the techniques applied by Member States.
It is clear that after the huge amounts of public money already poured into the banking sector, it will not be easy explaining to taxpayers why we need to do more. If asset relief for banks is to achieve sufficient public acceptance, it is essential that the banking sector is seen to provide an adequate quid quo pro. This cannot just be limited to restrictions on executive pay. It must also include a commitment to maintaining lending to the real economy and to carry out appropriate restructuring.
We are not rushing into any decisions that have not been carefully thought through and their impact assessed. But we do need to act soon. Measures to cleanse bank balance sheets can have a powerful effect to boost confidence and re-start lending. And they will be crucial if we want to see the full impact of fiscal stimulus measures.