The Government is Using the Wrong Tools to Fix the Economy

Treasury Secretary Geithner said today that the U.S. is "in a deep mess", but that the government will fix it.

But high-level officials of the Federal Reserve have slammed the government's response to the financial crisis.

And a Nobel laureate economist has said that the entire market for credit default swaps has to be changed, and that the superficial tinkering the government is now doing is not nearly enough.

Indeed, top experts have said that the government is using the wrong tools entirely to try to fix the economy.

In October, probably the top monetary economist alive told the Wall Street Journal that the government's approach to the crisis was wrong, because they were treating it as a liquidity crisis, when in was really a solvency crisis.

And Huffington Post pointed out yesterday that Nobel laureate Paul Krugman, economist James Galbraith, and - apparently - the chair of the Council of Economic Advisors, think the same thing:

Christina Romer, at a speech at the Brookings Institution Monday afternoon, appeared to give support to critics of Treasury Secretary Timothy Geithner who say that he is wrongly treating the economic collapse as a "liquidity crisis" when it is instead a crisis of solvency in the banking system brought on by a collapse in asset prices.

"Most obviously, like the Great Depression, today's downturn had its fundamental cause in the decline in asset prices and the failure or near-failure of financial institutions," she said in prepared remarks, where she compared and contrasted the current crisis with the Great Depression. The assets in question are, by and large, houses and other real estate....

It's more than just an academic question. The administration can't fix the economy if it can't accurately diagnose the problem. But if Romer did say publicly, in an explicit way, that the banking system faced a solvency crisis, that statement in itself could cause chaos in the markets as was seen on a smaller level when Sens. Chris Dodd (D-Conn.) and Charles Schumer (D-N.Y.) said they were open to nationalizing insolvent banks, causing CitiGroup and other bank stocks to dive.

Critics of Geithner, including Nobel Prize winning economist Paul Krugman, insist that the real problem is an asset collapse that led to a crisis of solvency in the banking system. In other words, Krugman argues that home values have come back to Earth, while Geithner hopes to solve the problem by pushing home values back to where they were. The conflict is a serious one because it dictates what response is appropriate.

Geithner's understanding of the crisis as one of liquidity -- which Fed chief Ben Bernanke agrees with -- leads to some bizarre conclusions, Krughman has written:

Thus, in a recent interview Tim Geithner, the Treasury secretary, tried to make a distinction between the "basic inherent economic value" of troubled assets and the "artificially depressed value" that those assets command right now. In recent transactions, even AAA-rated mortgage-backed securities have sold for less than 40 cents on the dollar, but Mr. Geithner seems to think they're worth much, much more.

And the government's job, he declared, is to "provide the financing to help get those markets working," pushing the price of toxic waste up to where it ought to be.

What's more, officials seem to believe that getting toxic waste properly priced would cure the ills of all our major financial institutions....

Economist James Galbraith, who has been critical of the administration's rescue effort as insufficient, said in an e-mail that "the recognition that the fundamental decline (collapse) in asset prices is the problem firmly contradicts the administration's line that credit is 'blocked' and can be made to 'flow.' The asset price (read: housing price) problem undercuts that completely, not so much by establishing insolvency of the banks, but by establishing the lack of credit-worthiness of the borrowers. Whether Christina Romer recognizes this is an interesting question."...

At a closed-door meeting with House Democrats on Monday night, according two members of Congress who were in the meeting, Geithner repeated that he believed the problem with the financial system was a lack of liquidity and that if he could get credit flowing again, the problem would right itself. Key to this analysis is the question of whether one thinks the rise of housing prices was an artificial bubble or if the collapse is reversible and we can return to those highs. Policymakers have resisted labeling it as a bubble. Romer, on Monday, came close, referring to a "run-up in housing prices that sure looks like a bubble."...

If the crisis is understood as one of liquidity, then the appropriate response is to continue injecting capital into the banking system and fiscal stimulus into the general economy until asset prices return toward previous highs. Japanese policymakers initially understood their crisis to be one of liquidity and injected hundreds of billions during the 1990s, to little effect. But if the problem is something different -- a solvency crisis brought on by essentially permanent asset-price declines -- then the policy response needed is different.

The stakes in taking the right approach to the crisis are obviously high. For example, PhD economist Marc Faber recently warned: “I think it might be far worse [than the great depression] precisely because of the interventions” by the government.