Paul Krugman is back to his old form on the financial services beat, now that the cracks in the Paulson/Geithner/Bernanke “give the banks what they want now, in size, worry about cleanup later” strategy is proving to have been the wrong way to go.
My big beef is that he didn’t go far enough and is WAAY too forgiving of the motivations and actions of Larry Summers and by extension, Team Obama.
Krugman draws the distinction, which is crucial, between capital markets operations and traditional banking, meaning on balance sheet lending (and some of that was treated as off balance sheet but really isn’t. Big case in point here is credit cards, where issuers are stepping in to shore up trusts that are showing much larger losses than anticipated). Krugman argues that the capital markets players have rebounded nicely, but lenders, on whom the economy depends too, are still in trouble:
…while the wheeler-dealer side of the financial industry, a k a trading operations, is highly profitable again, the part of banking that really matters — lending, which fuels investment and job creation — is not…
You may recall that earlier this year there was a big debate about how to get the banks lending again. Some analysts, myself included, argued that at least some major banks needed a large injection of capital from taxpayers, and that the only way to do this was to temporarily nationalize the most troubled banks. The debate faded out, however, after Citigroup and Bank of America, the banking system’s weakest links, announced surprise profits. All was well, we were told, now that the banks were profitable again.
But a funny thing happened on the way back to a sound banking system: last week both Citi and BofA announced losses in the third quarter. What happened?
Part of the answer is that those earlier profits were in part a figment of the accountants’ imaginations. More broadly, however, we’re looking at payback from the real economy. In the first phase of the crisis, Main Street was punished for Wall Street’s misdeeds; now broad economic distress, especially persistent high unemployment, is leading to big losses on mortgage loans and credit cards.
And here’s the thing: The continuing weakness of many banks is helping to perpetuate that economic distress. Banks remain reluctant to lend, and tight credit, especially for small businesses, stands in the way of the strong recovery we need.
Yves here. This is directionally correct, and I am glad to see Krugman bang the drum on nationalization, or temporary receivership, or whatever brand you need to slap on it to get Americans to stomach it. Taking out dud banks, resolving their bad loans, and recapitalizing and privatizing the viable parts has been shown to be the fastest way of a financial crisis. All other roads lead to Japan, and the Japanese told us loudly and clearly in the early stages of the crisis not to repeat their mistakes.
But there are a couple of crucial omissions. Recall that Meredith Whitney seemed a bit stunned at the brazenness of 1Q bank earnings games. She called the profits “manufactured” but also said the banks could keep it up for another quarter or two. And remember the other tidbit: the massive credit default swap unwinds by AIG at par in January and February. The beneficiaries of this largesse said they were the most profitable trades they had EVER seen. So a big stealth earnings (and balance sheet) boost, from taxpayers to banks via AIG was also part of the surprise 1Q results.
The other bit is that Krugman sees is that the continued grind of scarce credit on the real economy serves as a feedback loop back to banks. But there is no way to avoid a good bit of deleveraging pain. In the “best practice” examples of financial crisis resolution that everyone likes to point to (in particular, the Nordic countries in the early 1990s) all showed very nasty, but comparatively short downturns. And they all cut their rates with the ECU and used an export recovery to pull their economies out of the dumps. And ALL showed permanent reductions in their standard of living. But in the realm of painful choices, taking the hit early has led to better results than muddle-through and denial.
But we also have the bit where Krugman is far too kind to the Administration:
But as one critic recently put it: “There is no financial institution that exists today that is not the direct or indirect beneficiary of trillions of dollars of taxpayer support for the financial system.”….
So who was this thundering bank critic? None other than Lawrence Summers, the Obama administration’s chief economist — and one of the architects of the administration’s bank policy, which up until now has been to go easy on financial institutions and hope that they mend themselves.
Why the change in tone? Administration officials are furious at the way the financial industry, just months after receiving a gigantic taxpayer bailout, is lobbying fiercely against serious reform. But you have to wonder what they expected to happen. They followed a softly, softly policy, providing aid with few strings, back when all of Wall Street was on the ropes; this left them with very little leverage over firms like Goldman that are now, once again, making a lot of money.
Yves again. Dear readers, do you think the Adminstration’s supposed fury is sincere, or merely playing to the crowd? Actions speak louder than words. The Administration, ONLY because the public was rip-snorting mad, announced plans to have tougher reforms in June, with details of various measures coming over July and August. Many have been largely empty (grand promises like clawbacks, with no follow up of any substance, juxtaposed with the spectacle of the poor pay czar Kenneth Feinberg floundering with a hollow mandate). Worse, the supposedly substantive ones have been an utter joke. The “derivatives” (read credit default swaps) reform was misguided from the get-go. I was an early fan of the idea of putting them on exchanges, but I am now persuaded that that will never work (unlike real derivatives, you cannot have adequate initial margining. It would kill the product, hence you will have an inadequately capitalized exchange. And in the 1987 crash, the Merc was on the verge of failure, and if it had gone down, it would have taken down the NYSE, so exchange failures can propagate into related markets).
But not to worry, we won’t get that far, the Administration’s proposal had an industry-favoring loophole you could drive a truck through: only “standardized” contracts would trade on an exchange (or via a clearinghouse). So this reform was mere window dressing.
So why is the Administration so angry? It isn’t that there is no reform. There was never any intent to have real reform. The Administration has been an absolutely shameless backer of the banksters’ interests (and John Dizard remarked that central banks had gone from being vestal virgins to camp followers, so they are now in good company). It is the industry has become such pigs that they are making a joke of even the bogus reform put forward. They are so confident of their mastery of the gameboard that they are refusing even to go along with token concessions necessary to preserve appearances.
To put it more simply: The Executive Branch does not like being revealed as being a puppet of the banking industry. But it made this Faustian bargain, it has no one else to blame.