Krugman Imitates Andrew Mellon

In today's column, titled Wall Street Voodoo, Paul Krugman adopts at least part of Andrew Mellon's mantra,  "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," he said. "People will work harder, live more moral lives."

Krugman wants to liquidate the large banks.  He starts by creating an example of a hypothetical money center bank:

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So far so good. Not much different then my hypothetical bank balance sheet in a prior postwhere I tried to explain why it is meaningless to say that a bank is "technically insolvent" based on hypothetical mark to market accounting.

It is a little over simplified, since Gotham's toxic assets probably had a par value of $600 billion, had already been written down by $200 billion, and very likely couldn't be sold for $200 billion, since no one that would be likely to buy them wants to own more of them.  Krugman's critical assumption is that the current "market value" with poorly functioning credit markets and zero interest in complex asset backed securities is the best estimate of their economic value.  Krugman continues:

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

I would contend that Gotham isn't a typical zombie bank or institution. Anyone that remembers the true Zombie S&L's knows that they tend to double and triple down on their bets because they have nothing to lose. However, right now people are accusing the so called Zombie -- Gotham -- of refusing to loan out any of the TARP funds. Not the behavior of your typical zombie.

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future.

Here Krugman agrees that we can't just let the financial system blow up. He is saying that Lehman was a mistake but maybe not with Gotham, which is much larger.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

Not quite so fast -- this misses some critical details regarding what actually happened. First, the government already owned the failed banks, since they insured deposits through the FDIC and FSLIC. They then easily sold the performing loans and took the non performing loans -- see through office buildings were popular at the time -- put them in the RTC, and liquidated them. In the process they liquidated Texas. William Seidman sold it all, as quickly as possible, and drove the prices through the floor. A lot of people still remember and don't have particularly fond memories of this period. But this was only Texas, which at the time wasn't considered too big to fail. Perhaps most importantly, the liquidated assets were empty buildings and becoming less valuable by the day. This is fundamentally different then an asset backed security which is just a piece of paper. Unless you make the argument that the asset backed security, per se, is significantly impacting the value of the underlying assets, there is no inherent benefit of liquidating the paper as opposed to holding the paper. At this point Krugman backtracks and concedes the possible weaknesses in his arguments:

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?

Good questions. However, I think it is obvious that these toxic assets simply have to be held to maturity to see what they are worth. Liquidating them serves no purpose other then to drive down all asset prices. Whatever their theoretical market value is today, dumping a lot of them will make it lower. You simply can't liquidate your way out of this without producing a full blown financial panic, which Krugman recognizes.

The government already has trillions of dollars of assets on its balance sheet.  Most of these are good money at current price levels and there are reasonable prices that could be paid for the "toxic" asset backed paper -- once again, assuming that today's price levels are reasonable and there isn't significant general price deflation.  

So Krugman wants to liquidate Gotham.  Fine.

But it is one thing to liquidate Texas and another to liquidate the entire US -- including not just bankers but labor, stocks, all real estate.  I don't think the US is ready for the full Andrew Mellon treatment.  It was tried once and people still remember well enough not to want to try it again.