Opacity has a high price: Iceland shows a path not taken

In his NY Times column, Paul Krugman discusses the high price of opacity through the failure of the bank bailout doctrine to remedy a solvency crisis.

He looks at the case of Iceland and its decision not to bailout its banks.

He makes the incredibly important point that we did not have to make our citizenry pay the entire painful price.

I agree with Professor Krugman that as it was implemented, the bank bailout doctrine is a failure.  The problem was the implementation including the fact that it did not make capital pay a large part of that price.

Regular readers know that before bailing out the banks the government needed to require that each bank disclose its current asset, liability and off-balance sheet exposure detail.  With this information, market participants could figure out who was solvent and who was insolvent.

More importantly, market participants could figure out which of the insolvent banks had the capacity to "earn" its way back to solvency based on the strength of its franchise and which insolvent banks either needed a bailout or needed to be closed.

It is only by going through the steps of disclosure and then analysis that the market participants can be confident that the solvency issue is addressed.

It is only by going through these steps that banks are forced to recognize their losses and mark their assets to market.  This is where banks perform their safety valve function and protect the real economy and its citizenry from paying the full painful price of the banks' follies.

It is only when the assets are marked to market that banks are comfortable making new loans against similar assets and investors are comfortable buying these loans when packaged in structured finance securities that also have current asset level performance disclosure.

Under my proposed implementation of the bank bailout doctrine, the impact on the real economy, the pain placed on the citizenry and the amount of debt taken on by the government is minimized.

But it’s worth stepping back to look at the larger picture, namely the abject failure of an economic doctrine — a doctrine that has inflicted huge damage both in Europe and in the United States. 

The doctrine in question amounts to the assertion that, in the aftermath of a financial crisis, banks must be bailed out but the general public must pay the price. So a crisis brought on by deregulation becomes a reason to move even further to the right; a time of mass unemployment, instead of spurring public efforts to create jobs, becomes an era of austerity, in which government spending and social programs are slashed. 

This doctrine was sold both with claims that there was no alternative — that both bailouts and spending cuts were necessary to satisfy financial markets — and with claims that fiscal austerity would actually create jobs. 

The idea was that spending cuts would make consumers and businesses more confident. And this confidence would supposedly stimulate private spending, more than offsetting the depressing effects of government cutbacks...

Now, however, the results are in, and the picture isn’t pretty. Greece has been pushed by its austerity measures into an ever-deepening slump — and that slump, not lack of effort on the part of the Greek government, was the reason a classified report to European leaders concluded last week that the existing program there was unworkable. Britain’s economy has stalled under the impact of austerity, and confidence from both businesses and consumers has slumped, not soared....

So bailing out the banks while punishing workers is not, in fact, a recipe for prosperity. But was there any alternative? Well, that’s why I’m in Iceland, attending a conference about the country that did something different. 

... Iceland was supposed to be the ultimate economic disaster story: its runaway bankers saddled the country with huge debts and seemed to leave the nation in a hopeless position. 

But a funny thing happened on the way to economic Armageddon: Iceland’s very desperation made conventional behavior impossible, freeing the nation to break the rules. Where everyone else bailed out the bankers and made the public pay the price, Iceland let the banks go bust and actually expanded its social safety net. Where everyone else was fixated on trying to placate international investors, Iceland imposed temporary controls on the movement of capital to give itself room to maneuver. 

So how’s it going? Iceland hasn’t avoided major economic damage or a significant drop in living standards. But it has managed to limit both the rise in unemployment and the suffering of the most vulnerable; the social safety net has survived intact, as has the basic decency of its society. “Things could have been a lot worse” may not be the most stirring of slogans, but when everyone expected utter disaster, it amounts to a policy triumph. 

And there’s a lesson here for the rest of us: The suffering that so many of our citizens are facing is unnecessary. If this is a time of incredible pain and a much harsher society, that was a choice. It didn’t and doesn’t have to be this way.