Paul Krugman: Partying Like It’s 1929

http://www.nytimes.com/2008/03/21/opinion/21krugman.html?ei=5124&en=d4be1d2ea1520dfe&ex=1363752000&partner=permalink&exprod=permalink&pagewanted=print

by tomh • 18 years ago

32 19 18 years ago

nytimes.com

yummyfajitas2• 18 years ago

Paul Krugman is very confusing. It's almost like he is trying to fool people who don't understand the difference between savings and loan banks and investment banks ("shadow" banks, in his lingo).

The problem in 1930 was that depositors at savings and loan banks all wanted their money back simultaneously. Many people (read: main street) got screwed, leading to the creation of the FDIC. I.e., "the bank doesn't have your money. Sorry."

The problem today is that savings and loan banks gave out a bunch of loans to low quality borrowers. They then sold these loans to investment banks while misleading them about the quality (and the IB's just figured it out). "Conventional" banks (the ones PK seems to think are so great) screwed the "shadow" banks (those scary unregulated ones), and now investors are trying to avoid risky investments until things clear up.

Both are scary in a "trouble on wall street [financial word] [financial word] bad for the economy [financial word] [financial word]" sense. But beyond that, the situation is rather different.

pstuart• 18 years ago

I would have liked to see some recommendations rather than just hand-wringing.

My understanding is the crux of problem was the arm-twisting that went into having the ratings agencies grade them as low risk (make it look pretty if you want our business in the future).

I would think that the best "free market" solution would be increased transparency and tools to get these transactions out of the shadows.

giardini2• 18 years ago

Hogwash.

The problems lie squarely with the investment banks and firms who (1) failed to perform due diligence in their en mass purchases of morgages and (2) who sorted those mortgages into hi-, medium-, and low-risk "tranches" and then sold each tranch to other firms as Collateralized Mortgage Options (CMOs). The fault also lies with the bond rating firms who gave incorrect ratings to the CMOs so created.

To add to this morass, some investment firms bought up multiple hi-risk CMOs, then combined and re-tranched them into second-tier hi-, medium-, and low-risk tranches! They then somehow got high ratings for these second-tier CMOs from the bond rating firms!

Sure, savings and loans were giving out loans w/o checking properly, but had the investment firms been performing proper due diligence, the savings and loans would not have been able to sell them and the problem would not have occurred.

And since the concentration of leverage occured at the investment bank/firm level and only due to their creation of CMOs and meta-CMOs, they bear the responsibility for this snafu.

Unfortunately, all this makes no difference. The taxpayer will bail out the rich investment banks, the dollar will continue to weaken, our capital will be used up to protect large investment firms and less capital will be available for productive uses by small and large firms.

Wall Street wins and Main Street loses once again.

yummyfajitas2• 18 years ago

I agree completely about bailouts, they are ridiculous. Bear should be allowed to fail. That will teach the IB's to do a better job next time.

But I disagree with you that IB's didn't do their due diligence. Measuring the quality of individual mortgages isn't their job. The IB's job here is to build securities out of individual mortgages, given accurate knowledge of the mortgages from the ratings agencies and local banks.

It's a lot like trading commodities. A market maker in commodities doesn't need to know what a grade A cow looks like or how a cattle auction works. His job is to trust the cow raters to do their job while he packages sets of cows into financial futures. If a rancher is colluding with a cattle appraiser to pretend that 1000 mad cows are Grade A beef, it's not the fault of commodities traders (although commodities traders will be hurt).

The flaw with the mortgage market was not happening on the IB's end. The individual mortgages were not of the quality the local banks promised for various reasons you've outlined. They were then packaged into securities which were suitable only for higher quality loans. Those securities are failing now, and the market has become a lemon market (which killed liquidity) and caused all sorts of other problems.

Investment banks: "Given loans of known quality, we can package them into bond-like securities."

Local banks: "Pray, Mr. Investment Banker. If you put into the package loans of the wrong quality, will the right security come out?"

(With apologies to charles babbage)

davidw2• 18 years ago

BTW, if people are interested in economics, there's now a subreddit for it:

http://reddit.com/r/Economics/

Of course it gets some of the same wingnuts that the rest of reddit gets, but there are a few bright guys there.

astine• 18 years ago

'Safe banking' is a contradiction in terms. Every time you place money in another organization, their is an amount of risk involved. It only seems like it shouldn't be risky because the Fed guarantees so many banks and loans. This gives the banks more leeway to make risky loans and artificially shifts wealth around in the economy hurting the lower classes.

Fortunately, it also means that there is more to go around for startups.

kingkongrevenge• 18 years ago

This is such an unspoken truth. Depositors and investors have much more responsibility than the media ever pegs them with. I remember being impressed during the Enron thing with how nobody dared point out shareholder greed and ignorance. It was all about a few crooks at the top. Skilling and Lay were the bee's knees as long as the stock kept shooting up, even though there were tons of red flags in the accounting. Investors saw dollar signs and didn't do their homework.

tim2• 18 years ago

What? Why is it impossible for the risk to be negligable?

ctkrohn2• 18 years ago

I'm tired of reading articles like this. If you're going to blame the current crisis on a lack of regulation, please tell me what SPECIFIC regulations you would implement, and explain how they would have helped us avoid the situation we're in.

davidw2• 18 years ago

+1 - but that gets us into politics... and there lies madness.

Let's just leave articles like this for other sites. I think the economics reddit is a good place to discuss them, as mentioned below.

henning• 18 years ago

An op-ed column is not the place to get into policy wonkery.

bdt• 18 years ago

He's not advocating new regulations. The point of the article was that the Fed has knowingly allowed the shadow banking system to take over banks role in providing credit without requiring those organizations to bear the regulatory burdens of traditional banks.

The shadow banking system is exactly like the unregulated banks of the 1930s. And as we're now seeing, the result is another financial catastrophe.

http://en.wikipedia.org/wiki/Shadow_banking_system

ctkrohn2• 18 years ago

So how do you want to regulate the "shadow banking system" and the world of derivatives? What kind of reserve requirements should there be for traditionally off-balance-sheet derivatives? What kind of reporting requirements? If I come up with a new kind of funding structure -- something like a CDO, a SIV, whatever -- do I need to explain everything to the Fed first before going ahead with it? Who gets regulated: just the large non-depository investment banks? Smaller derivatives dealers and hedge funds?

I'm definitely sympathetic to the idea that regulators were asleep at the wheel. I just haven't yet seen any regulatory proposals that, if implemented, could have prevented the current crisis.

Prrometheus• 18 years ago

I personally can't stand Paul Krugman. I know he's done good work in academia, but his op-eds push a liberal agenda regardless of the evidence in favor of it.

In this case, how would the federal regulators know how to price risk better than the owners of financial businesses? Krugman doesn't say. He posits that they have some magic knowledge by virtue of being government agents.

The truth is, there was a unprecedented bubble in real estate values and real estate related debt. No one knew how to price them correctly. For a regulator to attempt to do so would be like a regulator setting the right price for Yahoo in 1999.

Neither does Krugman mention past failed financial regulation. Canada had only a handful of bank failures in the 1930's, compared with thousands in the US. The reason was that banks in the United States were kept small by anti-branch banking laws designed to keep any one bank from having too much power. The larger banks of Canada survived, not so the banks of the US.

What assurance do we have that the current regulators will get it right? Many people in public life seem to be drawing bad lessons from the current crisis so far. I'm inclined to think that they won't get it right.

mmmurf2• 18 years ago

Consider the current regulation that exists over the housing market:

- Mortgage interest deduction: In other words, you don't get a tax break for buying a house, you get it for being in debt b/c you bought a house. Hmm.. what incentive does this create?

- One time capital gains tax exemption for the sale of a home: This encourages people to sell their home and then buy a more expensive home, even if a less expensive one would have sufficed.

- The implicit federal bailout of Fannie and Freddie: These companies underwrite a lot of the more risky mortgages and as long as there is an expectation that the government will bail them out, nobody looks too closely at their soundness.

These are the regulations that got us into trouble in the first place.

Now is the time for less regulation, not more!

mmmurf2• 18 years ago

I have to say that these comments (the first 5 at least) are so refreshing. It's great that there are people out there who see through Krugman's propaganda.

bobbin• 18 years ago

More propaganda about the great depression. [here](http://www.freedomainradio.com/Traffic_Jams/great_depression...) is a lengthy podcast about the great depression and its causes.

Paul Krugman: Partying Like It’s 1929

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