Here is an informative article by Stiglitz, who actually disagrees with Krugman's outright nationalization idea. Instead, Stiglitz actually favors a variation of the good bank/bad bank idea. However, as noted here, Krugman does not like the good bank/bad bank idea, so you have two liberal nobel prize winning economists in disagreement:
http://krugman.blogs.nytimes.com/2009/03/08/anti-nationalization-arguments/Stiglitz notes his criticisms of both the GOP Proposal to insurance bank assets, as well as Geithner's plan for a private partnership:
http://www.thenation.com/doc/20090323/stiglitz/snip
The problem with America's banks is not just one of liquidity. Years of reckless behavior, including bad lending and gambling with derivatives, have left them, in effect, bankrupt. If our government were playing by the rules--which require shutting down banks with inadequate capital--many, if not most, banks would go out of business. But because faulty accounting practices don't force banks to mark down all their assets to current market prices, they may nominally meet capital requirements--at least for a while.
* * *
More recently, another idea has been put forward:
the government would insure bank losses. By removing the risk of loss, the value of these toxic assets automatically increases, improving the banks' balance sheets. Bankers love this idea. The government can give them a big insurance policy at a small premium.
Politicians love this idea too: there is at least a chance they will be out of Washington before the bills come due.
But that's precisely the problem with this approach: we won't know for years what it would do to the government's balance sheet. Six months ago, what the banks told us about their losses going forward was totally off the mark. AIG had to revise its losses by tens of billions of dollars within days. Real estate prices might fall only another 5 percent, or they could fall another 25 percent. With the insurance proposal, neither the government nor the banks have to admit the size of the hole in the banks' balance sheets. It's another example of those nontransparent transactions that got Wall Street into trouble. Even worse, the insurance proposal exacerbates incentive distortions--it moves us from a zero-sum world into a negative-sum world, where increased taxpayer losses are greater than Wall Street's gains. The insurance proposal may even inhibit banks from restructuring mortgages, worsening the problem that gave rise to the crisis in the first place. If they restructure the mortgage, they have to book a loss. If they keep the mortgage and things get worse (the likely scenario), the taxpayer picks up most of the downside risk; but if things get better and prices improve, the banks keep the gains.
* * *
Still worse are proposals to try to enlist the private sector to buy the trash.
Right now, the prices the private sector is willing to pay are so low that the banks aren't interested--it would make apparent the size of the hole in banks' balance sheets. But if the government insures private-sector investors--and even makes loans at favorable terms--they'll be willing to pay a higher price. With enough insurance and favorable enough loan terms, presto! We can make our banks solvent. But there is a sleight-of-hand here: go back to the zero-sum principle. The private sector is not going to provide money for nothing. It expects a return for providing capital and bearing risk. But its cost of capital is far higher than that of government. The losses are real, and the private sector won't bear them without full compensation. This means that the amount the government is likely to have to pay in the end is all the greater.
This proposal, like so many others emanating from the banking community, is based partially on the hope that if banks make things sufficiently complex and nontransparent, no one will notice the gift to the banking sector until it is too late. It appears as if they are at last getting the high market prices that they hoped they would get all along. But it would be a misnomer to call these market prices, since the government has taken away the downside risk. This proposal has, of course, the further advantage of drumming up support from the hedge funders, who so far have not received any of the TARP bonanza.
There is an underlying problem facing all these proposals: the hole in the banks' balance sheets is bigger than the $700 billion Congress has approved--and much of what has been spent so far has been wasted. So the financial wizards are turning to tried and true gimmicks--the same ones that got us into the mess. One strategy is to hide the costs in nontransparent accounting (easier under the insurance proposal). The other combines this trickery with the magic of leveraging and pretends that leveraging carries no risk. The government sets up a "special investment vehicle" using, say, $100 billion of TARP as the "equity." It then borrows another $900 billion from the Fed--which in rapid succession has been tripling and quadrupling its balance sheet. Of course, in doing so the Fed is risking taxpayers' money--but without having to ask permission of Congress. At best, this is a deliberate circumvention of democratic processes.
/snip
Edit: Note that this article appeared on March 4, 2009 before Geithner's plan was announced and finalized.
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