Martin Wolf and Paul Krugman share a worry: will Obama funk reform?

Martin Wolf's assessment today of Obama's handling of the banking crisis follows the same curve as Paul Krugman's last week. Both note Obama's essential conservatism, his wish to reform with as little upheaval as possible. Both allow (Krugman grudgingly) that the sequence of bailouts, stress tests and capital raisings, coupled with cheap money from the Fed, may have saved the 19 biggest banks, providing space for them to grow their way out of crisis. Both worry that preserving the status quo will lead to another blowup. Both wonder whether Obama has the chops to impose structural reforms.

The conservatism, in Krugman's eyes, is pusillamity; Obama has decided to "muddle through the financial crisis." Wolf has a more positive view:

“If we want things to stay as they are, things will have to change.” Thus wrote the Sicilian writer Giuseppe di Lampedusa, in The Leopard. This seems to me the guiding principle of the Obama presidency...In his own way, Mr. Obama is following the path trodden by Franklin Delano Roosevelt.

On the possiblity of short-term success, here's Krugman:

It’s a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again... maybe we can let the economy fix the banks instead of the other way around.

And Wolf:

The purpose of the exercise was indeed conservative: to make it credible, though not certain, that the existing banking system and assets can survive the likely battering. This has been done well enough to satisfy the markets. But these banks will also be unable to expand their balance sheet significantly in the near future.

Interestingly, both identify the chief long term danger as failure to reform. Krugman thinks that the banks see Obama as King Log, not King Stork:

...while the Federal Reserve and the Obama administration continue to insist that they’re committed to tighter financial regulation and greater oversight, Wall Street insiders are taking the mildness of bank policy so far as a sign that they’ll soon be able to go back to playing the same games as before.

Wolf cites more structural reasons to be skeptical that we'll get change we can believe in:

Ensuring the rescue of a financial system packed even more than before with complex and “too-big-to-fail” institutions may well be the cautious response to this crisis. But it leaves the government with the even more onerous task of imposing effective regulation in future. Unhappily, the record of regulation of generously insured financial systems is extremely poor. The mobilised self-interest of highly rewarded players easily overwhelms the constraints imposed by far less well-rewarded and almost certainly less able regulators.

The more the crisis unfolds, the more evident it is that incentives in the financial system were (and are) badly distorted. I sympathise with the conservative approach to crises, but not if it leaves in place the plethora of perverse incentives that created them. At the end of this, then, there will be one big test: will the number of institutions thought “too big to fail” be as large as now and, if so, how will they be controlled? If the answers are still not clear, there will need to be yet more change.

On the day this was published, the WSJ reported, "The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry," and Federal regulators outlined plans to regulate derivatives. First steps on a long road.

Paul Krugman goes wobbly

Paul Krugman has been one of the most relentless critics of the Obama Administration's handling of the banking crisis, complaining early and often that the capital injections, the stress test plan, the Public-Private Investment Program to create a market for toxic asset sales, etc. etc. are rewarding failure, avoiding hard choices, "perpetuating zombie banks, blocking economic recovery."

He may be right. But he's showing some green shoots of doubt. Here's his current assessment of the stress test strategy:

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.

It’s a strategy that might work. After all, right now the banks are lending at high interest rates, while paying virtually no interest on their (government-insured) deposits. Given enough time, the banks could be flush again.

After forecasting that the banks will not be well capitalized for a long time in the absence of massive government recapitalization, Krugman hedges again:

Can the economy recover even with weak banks? Maybe. Banks won’t be expanding credit any time soon, but government-backed lenders have stepped in to fill the gap. The Federal Reserve has expanded its credit by $1.2 trillion over the past year; Fannie Mae and Freddie Mac have become the principal sources of mortgage finance. So maybe we can let the economy fix the banks instead of the other way around.'

Then the pivot back to doomsday:

But there are many things that could go wrong.

Well, yes. But there are also many things that could go wrong with nationalization -- or any other plan. This is not to say that Krugman's core critique -- that Obama and Geithner are fostering zombie banks and shrinking from the full-scale industry restructuring that's need to put banking on a sustainable footing -- does not remain cogent.

But the Cassandra cry to which he devotes the second half of today's screed is pretty lame. He
worries that "the prospects for fundamental financial reform are fading." Evidence? That H. Rodgin Cohen, who was reportedly being considered for a deputy Treasury secretary position said a few days ago, "I am far from convinced there was something inherently wrong with the system."

Red alert! A prospective appointee is insufficiently zealous; ergo, Obama is going to wimp out on regulatory reform. Could happen, I guess. It's not yet clear how willing Obama is to break eggs, or heads, on any front where hard-core resistance threatens his core principles.

Nonetheless, it looks to me as if Krugman has downgraded his threat level a shade or two below orange.

Geithner: man with a plan

I will cop to having no economic basis to judge whether Timothy Geithner's plan to create a market for today's "toxic" debt securities will work. But Salon's Andrew Leonard has the right take on how Geithner -- and by extension, Obama -- have handled the process of forging policy:

From the very beginning, when Paulson told us that the subprime meltdown would be contained, to the very end of his tenure, there was never the sense that the Bush administration had a coherent strategy of any kind.

The same cannot be said of the Obama administration. Geithner's plan may well not work, and it may be too beholden to Wall Street, but its rollout has not been an exercise in helter-skelter chaos. In dealing with the economic crisis as a whole, the Obama administration has put into play a steady flow of initiatives that should, in theory, all work together. In addition to the stimulus, the housing plan and credit relief for small businesses, there's also been a budget proposal addressing long-term issues that even Paul Krugman found impossible not to praise. The Fed has been doing its part by engaging in its own extraordinarily broad-scale stimulative monetary policy.

All along, it has been universally agreed that the most glaring weakness of the Obama portfolio has been the lack of detail on how Geithner intended to tackle the banking system. But there is a difference between a lack of detail and utterly contradictory confusion. If we can hold our breath long enough to calmly assess the last two months, one can see that amid all the noise, the Obama administration has been moving carefully forward in one direction.

Geithner was very careful not to pin himself down on details during his confirmation hearing, except to say that the goal of his eventual plan would be to encourage more lending than would otherwise happen without government intervention. His first speech was widely criticized because he neither endorsed bank nationalization or provided enough detail for Wall Street to chew on. But ever since that speech, he's done pretty much exactly what he said he would do. The banks are being stress tested to determine their ability to survive an even worse downturn than we are currently experiencing. Capital will be made available to them to weather that storm. A "public-private" venture to create a market for toxic assets has been laid out. We have timelines and we have a strategy. The scheme outlined in the Treasury Department's White Paper may share an intellectual heritage with Hank Paulson's original cockeyed dream -- except for a rather large difference. It exists. It is real. It will either work or it will not.

I suspect that when the history of this financial crisis is written, Obama and co. will be seen to have steered a rational course, shaped largely by a terrifying inside view of the risks of systemic failure -- and that their decision making process will be recognized as reality-based, adjusting to failures as they happen, embracing complexity, and unswayed by ferocious criticism on all sides.

Which is not to say that those who claim it's futile to try to find value in the toxic assets or prop megabanks that may prove to be insolvent are not right. Here, too, Leonard has perfect pitch:

There is every reason to believe it will not work, and may even make things worse. There is every reason to doubt the fundamental assumption being made by the Treasury -- that the "true" value of the toxic assets is higher than their current market value...

But all the sturm-und-drang expressed hither and yon about how the Obama administration is damning us all to a decade or more of economic doldrums by not pursuing immediate bank nationalization today, is just a bit overwrought. The U.S. economy is not going to stop shedding a half million jobs a month if we nationalize Citigroup today, instead of two months from now. We are deep in a recession and it will be quite awhile before we crawl out of it. Two months of caution do not mandate a "lost decade." Indeed, we will know in a matter of months whether the Obama administration's current efforts are gaining any traction, and if they aren't, then there will be no other alternatives. Perhaps the smartest thing that Geithner's critics could do is to just step aside and let him fail.

It's worth keeping in mind in this context that Nouriel Roubini, while forecasting/advocating the nationalization of a number of large banks, suggested that the time won't be ripe for approximately six months. I sometimes suspect that Obama, if not Geithner, suspects or knows that several of the largest banks can't be saved and is preparing the ground for the moment when nationalization emerges as "the worst possible option except for all the alternatives." If so, he would follow Roosevelt entering World War II and Lincoln issuing the Emancipation Proclamation - waiting for the moment when he can forge consensus around the inevitable.