Paul Krugmans Bailout Dissent

Image: Robin Eley

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Before winning this year’s Nobel Memorial Prize in Economic Sciences, New York Times columnist Paul Krugman had been passed over for the Pulitzer Prize in 2002, 2003, 2004, and 2006. Come the next round of Pulitzers, in April, we’ll see if the journalistic savants at Columbia were able to figure out that Krugman also wrote the single most important newspaper column of this fall’s meltdown. When the financial press was calling for immediate passage of Hank Paulson’s now-infamous three-page bailout plan, Krugman spotted its fatal flaw.

In a scathing column on September 22, Krugman noted that Treasury Secretary Paulson had the wrong end of the stick. At the time, Paulson wanted unilateral authority to buy up $700 billion worth of toxic mortgages from his bankrupt buddies on Wall Street. Krugman quickly saw that another round of debt bundling would fail to inject cash into the credit markets. “The financial system needs more capital,” he wrote. “And if the government is going to provide capital to financial firms, it should get what people who provide capital are entitled to—a share in ownership, so that if the rescue plan works, all the gains don’t go to the people who made the mess in the first place.”

In subsequent columns and blog posts, Krugman laid out a strategy to infuse cash into the frozen credit markets by having the government buy stock in depository banks of the traditional sort. Unlike investment banks, such as Lehman, depository banks are insured and regulated. By buying stock that it could later resell, the government would create a chance for taxpayers to be compensated for the cost of the bailout.

But Paulson initially insisted that his $700 billion had to be used on toxic mortgages instead of bank stocks, thereby throwing good money after bad. How did Paulson get it so wrong from the start? It had to do partly with the U.S. Treasury Department’s ignoring (or, God help us, not understanding) a stopgap mechanism commonly used around the world. In such cases, the lesser of evils is for the government to recapitalize the major commercial banks by taking temporary ownership of them. Asked why Paulson was so intransigent, Krugman speculated that Paulson, who is regarded as very smart, may have been playing to what was left of Bush’s ideology. Then Krugman offered another reason, which hearkened back to investment banking’s hubristic Masters of the Universe period. In the ’90s, the central myth of investment bank infallibility seduced all but a few Manhattan business reporters, and judging from their initial broadcasts on the current crisis, a lot of journalists at MSNBC, CNBC, and CNN were of the same mind.Goldman Sachs—the House of Paulson, Robert Rubin, and Jon Corzine—was infallibility central.

“it was the goldman sachs thing, the belief that with a lot of fancy footwork, you can do things that make no financial sense,” Krugman told me of his first reaction to the Paulson plan. “People in the financial industry make hundreds of millions doing this sort of thing”—that is, repackaging bad debt as financial instruments—“but it doesn’t work in an international economic crisis of this scale.”

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