We have been saying for some time that the policy premise of the Fed and Treasury has been that the financial crisis is that it is a liquidity crisis, not a solvency crisis. If you are of that school, the fallen prices of various assets is due to a combination of scarcity of funding plus irrational panic. Find ways to provide liquidity and give investors that magic elixir, confidence, and voila, crisis over.I think her analysis here speaks to a hugely critical truth. In trying to understand this financial crisis, we are increasingly falling into two distinct camps: (1) It’s a liquidity crisis (pump more money into the system, soothe irrational investors, and all will be fine (2) It’s a solvency crisis (the financial system is semi-paralyzed because the banks (not all, but enough, and the systemically key ones morevoer) are effectively bankrupt).
Having watched the credit markets closely before the implosion, we'll agree there was plenty of irrationality. But it was in the gross underpricing of risk. The snapback to current pricing to us thus seems a return to rationality plus new fundamentals based on borrowers who never should have been lent money in the first place defaulting on such a scale as to damage overall economic activity. And that means, as plenty of Serious Economists (Krugman, Buiter, Stiglitz, to name a few) have warned, the Geithner cash for trash program is a huge misallocation of taxpayer dollars. Even granting that something must be done about the banking system, this is a covert and wasteful way to go about it.
My position is clear. I’m in with the #2 camp. So are many Serious Economists, as Yves notes. In fact hardly anyone credible believes #1 is true anymore. Unfortunately the small coterie of #1 diehards belongs to the Obama administration: Geithner, Summers et al. So we agree to disagree and no harm done, right?
Wrong, because believing in #1 (solve the liquidity problem and the bad stuff goes away!) leads you down a very different policy path. Meanwhile, the stakes are high. Public patience is thinning. Time is of the essence. Can you really afford to be wrong? There is a view (held by Mark Thoma, among others) that it’s okay to throw tepid support behind the Geithner plan, even though you may harbor a few reservations. If it doesn’t work, we’ll just try Plan B.
The trouble is, every squandered opportunity paints us even further into a corner. The worst outcome for the Geithner plan may be simply that nobody shows up. The Treasury buys the auction paddles, rents the venue, and the banks and private investors basically decide to stay away. The corrosive cynicism afoot in America deepens. Geithner, dragging the baggage of a failed plan behind him, casts about for yet another solution. Can we really pretend that this doesn’t carry a serious cost?
What Yves points out here to me is brilliantly obvious, but too rarely remarked on. We are acknowledged to be in a “post bubble” phase. If that is true, and you have to reconcile the price of an asset, would you go with its valuation as set during the bubble or after? The answer is so clear as to be obvious to a child.
But the new “post bubble” asset prices the banks deride as “fire sale.” They began this labeling early, smartly getting out in front of the bad news that many of their assets were rotten. The U.S. government has gamely run with this bit of wormy apple polishing. But just think about what’s more likely: That the bad assets were priced correctly before (in the middle of the froth and exuberance) or that they are priced correctly now (when the scales have fallen from our eyes and we know that there is no risk-free ride)?