Krugman vs. DeLong

The excellent U.C. Berkeley economics professor Brad DeLong says his main principles are: “Paul Krugman is right” and “If your analysis leads you to conclude that Paul Krugman is wrong, refer to rule #1.”

Since DeLong’s not one of the masses of know-nothing Krugman-bashers, I read with great interest his post “I Think Paul Krugman Is Wrong.”

DeLong’s primary disagreement with Krugman boils down to this: Krugman believes toxic bank assets are toxic, so taxpayers should not pay much for them (unless we restructure the banks and wipe out owners and possibly creditors too). DeLong believes the assets have two possible values: low — if the government plan fails to solve the banking and economic problems — or moderate — if the government plan substantially stimulates bank lending and boosts the economy. DeLong is willing for the government to “overpay” (relative to what private parties are willing to pay today) because the very act of overpaying for so many bank assets will substantially improve bank balance sheets, which — he claims — should boost the economy and raise the value of those currently toxic assets.

Both arguments are plausible, but I’m inclined to agree with Krugman. To agree with DeLong, you need to believe two things:

  1. Government purchases of toxic assets will largely solve the current banking and economic crises.

  2. Financial benefits of a government bailout that rescues private investors from horrible investment decisions should flow to private investors, not the government and taxpayers.

DeLong’s critique deserves consideration, but I suspect #1 is overly optimistic, and #2 seems unfair.

One reason I doubt #1 is that house prices have fallen so far, so many jobs are being lost, and so many people have so little home equity that it’s easy to imagine large-scale foreclosures and home abandonment by people whose mortgages are larger than their home values. Even worse, in areas with heavy concentrations of foreclosures and home abandonment, communities are being destroyed, pulling down the prices of all nearby houses. Giving insolvent banks cash won’t solve the house price problem or the job loss problem or the blighted neighborhood problem.

Posted by James on Monday, March 23, 2009