A More Optimistic Take

From DeLong. Krugman, conversely, remains skeptical. Critics were right to note below that the epistemic uncertainty here demands more modesty than I showed; this crisis has so few even close precedents it’s hard to now anything. So let’s say that I remain much more convinced by the latter position. This is the key point:

If you think it’s just a panic, then the government can pull a magic trick: by stepping in to buy the assets banks are selling, it can make banks look solvent again, and end the run. Yippee! And sometimes that really does work.

But if you think that the banks really, really have made lousy investments, this won’t work at all; it will simply be a waste of taxpayer money. To keep the banks operating, you need to provide a real backstop — you need to guarantee their debts, and seize ownership of those banks that don’t have enough assets to cover their debts; that’s the Swedish solution, it’s what we eventually did with our own S&Ls.

Now, early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that’s an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong. Time for a Swedish solution.

Particularly with real estate prices still falling, I think Krugman is correct that the idea that this is just a bank run as opposed financial institutions suffering from extremely bad bets is extremely implausible. And if this is true, then Geithner/Summers strikes me as nearly indefensible.