In which I disagree with Paul Krugman


As James Surowiecki points out here, my views on what’s entailed in bank nationalisation differ significantly from those of Paul Krugman[1]. Krugman, like quite a few other advocates of nationalisation, has in mind models like the Resolution Trust Corporation and the Swedish nationalizations of the 1990s, where the government took insolvent institutions into temporary public ownership, liquidated the bad assets and returned them to the private sector. These solutions worked well because the global financial system as a whole was solvent and liquid, even though some sectors (US S&Ls, Swedish banks) were not.

What’s needed in the present case is not only to fix the problems of individual banks, problems on a much bigger scale than have been seen before (even in the leadup to the Great Depression, the financial sector played a smaller role in the economy than in the recent bubble), but to reconstruct a failed global financial system. It’s kind of like rewiring an electrical system in near-meltdown, while keeping the power on (this is possible, but tricky and dangerous). The job is likely to be much slower than the rescues mentioned above, and the institutions that emerge from it will be very different from those that went in.

But, contra Surowiecki this time, this only strengthens the argument for nationalisation. Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

fn1. Krugman is well-known for being right when lots of others have been wrong, so take this into account in assessing the arguments.

22 thoughts on “In which I disagree with Paul Krugman

  1. Where have all the commentators fled,long time passing,when will they ever learn,when will they ever learn. So it seems you are refering to the United States of any descriptive A word. Whereas if you were refering to our system,I would simply use the GST, as a deposits system,and disallow the Australian Banks to use funds put through them for stabilising purposes,but could go to the tax office with some of its requirements to be dutifully analysed by people like yourself. The rest is the drama of legislation,and limitation setting in such.

  2. One way to nationalise banks, but maintain arms length, is to do so through a Sovereign Wealth Fund (e.g., Australia’s Future Fund). Transfer money to the SWF for the express purpose of buying equity from banks with instructions to replace the board and management, and give the SWF (say) 10 years to return the money to the government. 10 years should give the SWF enough time to sell down its investment in banks at the highest possible price.

  3. John, You get to the point where you say you don’t want a nationalisation followed by a quick re-privatisation but then it doesn’t go anywhere. You know what you don’t want but not what you want! Not that I have any better proposals – the Krugman course seems to me similar in effect to receivership* – but to say you don’t like what Krugman wants alone doesn’t help. Where to then?

    You say that the international financial system requires reconfiguring. Is this something that affects the way you handle individual national banks facing insolvency?

    *Neither proposal would require that existing managers remain in place though some would need to. Are you saying that managers should be chosen without a background as bankers?

  4. Harry, I’ve spelt out my proposals for a reconstruction of national regulation, based on narrow banking, quite a few times now. I agree that the details of a global infrastructure are pretty hazy, but the central point must be to prevent global capital flows from undermining sensible national regulation.

    On the choice of managers, I’d be looking for people with a track record of conservatism and scepticism about financial innovation, as well as understanding of the principles of banking. Hard to find, but some oldish financial regulators or central bankers and really old private bankers might fit the bill. Then we need people with experience in corporate restructuring. What we don’t need at the top is anybody whose most notable experience is that of being a senior banker in the last decade or so.

  5. Good old fashioned prudence JQ is what is needed. Im not even so sure we should have deregulated financial capital to be able to circle the globe at the push of a button because all the black money does just the same and so much of it is purely speculative. We need the sort of banking men you would see in old black and white Hollywood movies that know how to hang on to it and not expect as a matter of course to make a zillion gambling with the customers money!

  6. Harry, it seems to me that John is saying that there’s no “quick fix” available here, that things that have been used in the past are not necessarily able to be cut and pasted into the present. It will take time to work out what a good approach might be.

    Paul’s focus is in trying to prevent immediate damage. John’s focus is a bit longer.

  7. But at a certain point Im scared we are all falling into the liquidity trap by worrying so much about how to give money to banks and in the end it may prove a pointless and expensive exercise especially if the boom multiplied the number of financial institutions beyond a sustainable amount. The sackings have started on the streets and I feel you can count on the deposits of ordinary customers much more when it comes to rebuilding banks, than any deals done between banks and the government. At the end of the day the government can only offer small deals relative to working population.

  8. Regardless, there will be more bank failures to come and dont forget the horror of bankrupt government departments in the US in 1930s where teachers wages were ceased etc. The thing that is most horrific in all of this, is that those who so richly rewarded themselves in the interest of being “competitive” will still own all the trappings of wealth and will not bear the brunt at all. I hope some companies at least see how wrong this is and act on it. Some seem to have started to reducing executive salaries by up to 50% but look at Moss – even if it was halved we are still talking 11 million pa and the rest of the millionaires at the millionaire factory.
    There is one regulation that is badly needed and that is giving shareholders some binding power over executive / high level managerial remunerations.

  9. I would see more benefit in Keynesian style fiscal interventions than money beyond a basic protection of savings level which is already in place.

  10. “There is one regulation that is badly needed and that is giving shareholders some binding power over executive / high level managerial remunerations.”

    True. I find it remarkable that the owners of any business should not be given a say on how much they are willing to pay an employee.

    Executives should have to front shareholders and say “this is how much I think I’m worth to this company”, and the shareholders can say “aye” or “nay”.

  11. I’m wondering at what stage the smaller banks in America start tumbling in greater numbers. Perhaps they won’t but I wouldn’t bet the bank on it, so to speak.

    In Australia however, I would be more concerned about the superannuation providers – anyone know what risks are there, potentially?

  12. Donald# I fear that as well but I also fear the ramifications on governments of directing too much in bailouts into it. It could be a bottomless pit that no amount of available bailout money could stop.

  13. T#12 The economy doesnt only run on lending alone. Its about spending as well and lots of people dont borrow to spend. We seem to have a bit of a one sided focus on banks.I know bank failures are alarming but approx two thirds of them were decimated in 1890s crash. Are we spreading our response to this crisis too thinly by concentrating on the lending side and bank bailouts? There may just be too many of them to worry about.

  14. JQ Said

    “reconstruct a failed global financial system”

    A little bit of de javu and bank bashing.

    The Reconstruction Finance Corporation gave aid to state and local governments and made loans to banks, railroads, farm mortgage associations, and other businesses.

    Democratic politicians argued with some justification that federal assistance was going to the wrong end of the economic pyramid. They believed that recovery would not occur until the people at the bottom of the heap had their purchasing power restored, but the RFC poured money in at the top. To many Americans, the Reconstruction Finance Corporation was viewed as a relief program for big business only.

    So Congress forced the naming of the banks seeking loans, the amounts and the names of the recipient companies were made public. This requirement had the unfortunate effect of undermining confidence in the institutions that sought loans. Too often, for example, a bank that asked for federal assistance suffered an immediate run on its funds by worried depositors.

    Back in the 1930s they went with bailouts, what is interesting is The total amount from 1932 through 1941 was $9.465 billion and GDP contracted about 30% form 1929 to 1932 in the US.

  15. Nick N @9. Fully concur with the need to change corporate laws to give shareholders ownership rights.

  16. Question to John Quiggin.

    Suppose laws are changed such that there will be ‘narrow banks’ within regulatory frameworks under national government controls that are immune to be negatively affected by international economic activity. (If the latter involves financial capital flow restrictions – capital controls – then I’ll set this aside in the following because it does not affect my argument.)

    Question: How would ‘narrow banks’ affect the ability of non-bank private enterprise to create credit and indeed excess credit such that the financial system collapses? I am thinking of trade credits (accounts receivables in the terminology of accrual accounting)and associated credit rating agencies.

  17. John (on #4), Policies for regulating international capital flows are complicated. There are resource allocative benefits from capital market integration – the gains from trade – but costs in terms of vunerability to systematic risks of misfiguring returns and risk. It seems to me a smart economic theorist could devote energies to working on the tradeoffs here.

    It used to be that restrictions were only favoured for countries like Thailand with weak banking systems. What a pretentious and erroneous view that has proved to be.

    Clearly the assumption that people invest on the basis of good information is tenuous.

  18. Krugman was asked by a journalist the day he won the Nobel Prize whether a new Bretton Woods is required. He said no, on the grounds that during the GFC exchange rates have actually behaved quite well. If international capital flows were a problem, that wouldn’t be true, so the international financial architecture is the one thing that doesn’t need fixing.

    I reckon Krugman might be right. Now of course it’s true that the crisis has a huge international dimension but it seems to be a collection of national problems rather than an international problem as such. It’s really hard to see where or how the flow of money between countries has been a causal factor in all of this.

    So why have so many countries been affected by a virus that started on all Wall Street? Because of the flow of ideas between countries. The key idea was that it was smart banking to grow your balance sheet as fast as possible. It became a world-wide fashion, like body shirts and flared pants in the ’70s. And why not? When managers’ remuneration was tied directly to balance sheet growth, the outcome was predictable and predicted (by some). And the managers knew perfectly well that by the time it all hit the fan they would be long gone, having collected their bonuses and retired to the south of France.

    There was another international factor at play and that was the Basel regulations. Financial institutions all over the world were subject to them. The OECD reckons a key factor was banks arbitraging the changeover from Basel 1 to Basel 2 around 2004.

    And finally, no doubt making things much worse, was the view (really an ideology) that bank managers had to be paid squillions or they’d go off and become bank managers in other countries. This was another international factor. But by what performance benchmark can you pay them squillions? By linking their pay to asset growth (never mind the quality). Assets can grow by hundreds of % every year with enough inventiveness (CDOs, CDO squareds CDO cubeds etc) – problem solved.

    So it’s not really a matter of a new international financial architecture, unless that is defined as new bank regulations that are implemented by national authorities, world wide.

    No doubt, bank nationalisations will take place in many countries, and that can be seen as an international solution. But they won’t take place everywhere – probably not Australia, unless our banks are in much worse shape than everyone is saying. What will have to happen is that where banks are nationalised, they will have to be fully nationalised. Partial nationalisation is the worst of all worlds. As Alan Kohler said yesterday, in Britain, the same idiot managers who created the problems in the first place are still there, only now their idiocy is being explicitly underwritten by the tax payers. When banks are bust, it’s because they have been busted by the people running them. They will have to be cleaned out totally as matter of policy, and that will require full government control, not a passive equity stake.

  19. Uncle M. (#17) notes the importance of Basel II – but wasn’t the rather bigger problem (and a source of banking arbitrage) the refusal of the US to sign up to Basel II? (it started coming into the tent only late and reluctantly). When a quarter of the world’s economy plays according to different financial system rules, the chances are that something will go wrong. That said, BIS and Basel II have all the hallmarks of setting the rules based on fighting the last war – Basel II would have helped in preventing a Nick Leeson, Barings scenario, but that’s not what happened.

  20. Uncle Milton @17: “…rather than an international problem as such. It’s really hard to see where or how the flow of money between countries has been a causal factor in all of this.”

    Yes, indeed it is hard to see – interbank swap arrangements are not shown on the balance sheets.

    Also multinational corporations transfer monetary values between juristictions via transfer pricing.

  21. There is a lot of explanation for this collapse and its sitting idle as slush money in swiss bank accounts I would suggest. A market can get too top heavy and fall on itself and think this is what has happened – controls and regulations laxened while few were losing money. Off balance sheet is what worries me although a accountant friend of mine explained it very reasonably how some things need to be off balance sheet and I understood it clearly – but thats not to say the off balance sheet provisions have not been exploited by the accounting loophole seeking wizards (although I now need another accountant to explain it to me again because I have forgotten the example!)

  22. A question to any who know and are game to say – just how many major banks in the world right now are insolvent? JQ’s peice seems to imply quite a few are, and Krugman’s corresponding recent blog virtually says that Citybank (sorry Gothambank) is.

    I ask because, my simple understanding was that publicaly listed companies, including banks, have ot advise share markets of POTENTIAL losses. So even if the answer is “we don’t kow how much we have lost” they still have to tel. Don’t they?

    Either way, derivatives and credit default swaps are consigned to the dustbin of economic history. Years ago I could not understand the markets for junk bonds, then futures, then derivatives, and now CDSs. Turns out there was nothing to understand.

    One more dumb question – if everyone has huge debts from these things, who has the capital now? Lately it seems as though everyone is afraid to lend to everyone else. Are they all insolvent? If so, just where is the money?

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