Kelly and Krugman on Muddling Through the Crisis

From Kelly Letter Note 15 sent Feb. 15:

The government is hoping the economy gets back on its feet soon, and that crap assets move up in value to recapitalize banks naturally. Rising home prices, for example, would go a long way toward that end. To give better odds of this scenario working out, the government is leaning toward guaranteeing crap assets so banks can keep operating in an under-capitalized state while waiting for the economy to recover.

Few economists expect that to work out. Most see the scenario going like this: government muddles along for much of this year with various stop-gap measures to prop up the bankrupt banking system, realizes in nine or 12 months that the economy is waiting on the banks as much as the banks are waiting on the economy, and finally bites the bullet with a massive bank nationalization effort.

I think Paul Krugman at The New York Times has a friend on The Kelly Letter subscriber list. He wrote in his column last Thursday:

What we’re really seeing here is a decision on the part of President Obama and his officials to muddle through the financial crisis, hoping that the banks can earn their way back to health.

Remember, it was the markets, not the government, that in effect declared the banks undercapitalized. And while market indicators of distrust in banks, like the interest rates on bank bonds and the prices of bank credit-default swaps, have fallen somewhat in recent weeks, they’re still at levels that would have been considered inconceivable before the crisis.

As a result, the odds are that the financial system won’t function normally until the crucial players get much stronger financially than they are now. Yet the Obama administration has decided not to do anything dramatic to recapitalize the banks.

Finally, given the possibility of bigger losses in the future, the government’s evident unwillingness either to own banks or let them fail creates a heads-they-win-tails-we-lose situation. If all goes well, the bankers will win big. If the current strategy fails, taxpayers will be forced to pay for another bailout.

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