06.13.2011 0

Krugman’s Awakening?

Paul KrugmanBy Bill Wilson – It’s the second time within a month, but I agree with the New York Times’ Paul Krugman.  This time, he writes that “bankers and wealthy individuals with lots of bonds in their portfolios” can count on the government to “protect the interests of creditors, no matter the cost”.

Now, we would certainly disagree on which policies are intent on preserving creditor interests and therefore do not deserve to be enacted.  Krugman is primarily concerned with opposition to deficit-spending, which he says is because officials believe such spending unbridled “might hurt the interests of existing bondholders.”

Only if it leads to a catastrophic default, I would note, because the national debt became so large that it could not be refinanced, let alone be repaid.  But then, the reason to avoid a complete default is because it would presumably be harmful to everyone, not just creditors.

Leaving that aside, it must be noted that Krugman doesn’t completely hold the high ground when it comes to propping up creditors.  He was a supporter of the 2008 bank bailouts, which on their face protected bankers who bet poorly on housing, because, he wrote, “the danger of financial panic if it doesn’t go through, makes it worth passing”.

When the first draft of the plan was released, he warned that “it seems all too likely that a ‘fair price’ for mortgage-related assets will still leave much of the financial sector in trouble”.   Instead, Krugman advocated that if the plan was for government to buy mortgage-backed securities, that it “will only work if the prices Treasury pays are much higher than current market prices”.

His major gripe with the initial plan was that it was not clear if the government would take equity in troubled firms.  In the end, equity was a part of the deal, and so Krugman agreed to the bailout.  With a government stake in the firms that took TARP money, he had no problem with propping up investors who bet poorly on an asset, in that case, mortgage-backed securities.

And ultimately, it was not the Treasury, but the Federal Reserve that wound up giving investors 100 cents on the dollar for the securities, with a $1.25 trillion bailout that propped up financial institutions all over the world.  And certainly, the bailout’s aim was to “protect the interests of creditors, no matter the cost.”

Because, the very institutions that the U.S. depends on to lend us trillions of dollars for all the deficit-spending Krugman insists is necessary to “create jobs” would have been rendered insolvent.

But leaving that aside, since 2008, Krugman has taken a slightly harder line against the bankers, as evidenced by his most recent piece.  He’s not out of the woods yet, but I’m holding out hope.  The best example of Krugman’s awakening was a piece on he wrote last year on Iceland, a nation that let its banks fail in 2008 because they were too big to save.

As noted by Bloomberg News, at the time the crisis hit in 2008, “the banks had debts equal to 10 times Iceland’s $12 billion GDP.” Krugman noted that with its policy — which let bankers take big losses — both unemployment and growth were recovering in Iceland.

Krugman wrote, “The moral of the story seems to be that if you’re going to have a crisis, it’s better to have a really, really bad one. Otherwise, you’ll end up taking the advice of people who assure you that even more suffering will cure what ails you.”

Most recently, he remarked on how Iceland is now in a better position than Ireland, which did bail out its banks.  He links to a couple of stories on how credit default swaps on Icelandic debt have dropped to 200 points, while Ireland’s are at 683 points.

He writes, “Why, it’s almost as if defaulting on debts run up by runaway bankers and letting your currency depreciate works better — even from the point of view of investors — than socializing private-sector losses and grimly sticking with a fixed exchange rate.”

A quick point: Iceland did not default, it told banks that failed they weren’t being saved.  But, leaving this semantic point aside, again, I agree with Krugman: making creditors pay when they bet poorly on housing has been a big benefit to the Icelandic economy.

The reason, which Krugman fails to note, is because Iceland has not been saddled with the tremendous costs and run-up in national debt that Ireland has been paying for with its bailouts.  That’s the only real difference between the two.

Government spending on bailouts therefore diverts resources away from private sector economic recovery, and instead goes to propping up creditors and investors.  Meanwhile, the national debt becomes ever-larger, which then becomes a major drag on the national economy.

This is where Krugman and I part ways.  He does not perceive any risk of a national default in the U.S., where the national debt will run up to over $26 trillion by 2021, and is committed to a deficit-spending formula to prop up the economy.  So, he has no problem with further trillions of dollars of “stimulus,” which he maintains have been insufficient.  He wants more spending.

But, as Europe is learning, the risk of default from too much spending is very much real. The question now is, in the sovereign debt crisis, if creditors bet poorly on government bonds, should they take losses on the bad investments?

That’s what Germany is now advocating for on Greek debt, where bondholders would be given bonds with longer maturities, stretching them out by seven years.

This contrasts with France and the European Central Bank’s (ECB) approach of forcing bondholders to keep on purchasing Greek debt, no matter how risky.  The European Central Bank too is on the hook directly for €45 billion in Greek debt, not to mention tens of billions of Greek debt it accepted as collateral when making loans.  France too owns about €10.28 billion of Greece’s €340 billion debt.

Of course these banks want another bailout. They cannot afford to take losses of that magnitude.  The ECB believes the German proposal will trigger a “credit event,” increasing the risk of default in other eurozone nations.

They may be right.  It’s a default by any definition, since Greece will not be paying on time and in full, and that will certainly result in losses by the bondholders.  Those institutional investors, in turn, will then have less money to lend to other nations like Portugal, Ireland, Italy, and Spain, leading to more defaults.

But, just because banks that bet poorly on sovereign debt will lose out does not mean the defaults shouldn’t happen.  So far, Germany appears to have the upper hand, and have won the support of the Dutch.  In Finland, the idea of bondholders taking losses on sovereign debt has become increasingly popular.

It’s hard to predict where Krugman will come out on the side of.  As a career-committed Keynesian who believes in deficit-spending to “create jobs” as a matter of faith, he needs the bankers.

On the other hand, if he can see the perversity of government “protect[ing] the interests of creditors, no matter the cost”, then perhaps we are witnessing an awakening by Krugman? One can only hope.  The creditors should pay, just like any other investor, when they bet poorly.

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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