Paul Krugman explains how academics from well-known universities effect policy response to financial crisis

In his NY Times blog, Professor Paul Krugman does a great job of explaining how academics from well-known universities have influenced the debate on how to end our current bank solvency led financial crisis.

Regular readers know that your humble blogger thinks their biggest contribution is to crowd out discussion of alternatives to end the financial crisis.

Professor Krugman explains how this crowding out mechanism works with Reinhart/Rogoff and austerity.

But before looking at his post, I would like readers to ask themselves one question: why were these or any academics listened to in the first place?

There are two reasons:

1. The reputation of the institution that they work at; and
2. The idea that a professor at one of these institutions in finance or economics would actually have some idea what they are talking about.

Between Reinhart/Rogoff's error filled paper supporting austerity and the finance and economics professions' failure to loudly warn let alone predict the financial crisis, it is clear that the idea finance or economics professors know what they are talking about isn't true.

Reinhart/Rogoff's paper confirmed that when it comes to peer reviewed papers in finance and economics there effectively is no minimum hurdle or standard they have to get over to get published.  So any fundamentally flawed idea can be published.

Regular readers first encountered this with Yale Professor Gary Gorton using bank demand deposits as an example to illustrate his concept of informationally insensitive debt (hint: deposit insurance is information as any 6-year old opening a bank account can tell you).

Reinhart/Rogoff's paper also confirmed Cullen Roche's observation that every single school of economics exists to promote a political agenda.  In this case, the authors were well paid shills for the austerity agenda.

One other point before I return to Professor Krugman's blog.  The reputation of the institutions acts to magnify the importance of what these professors say.  Do you think the austerity agenda would frequently cite the work of a junior college professor or a random blogger?

No!  Policymakers who are predisposed to these fundamentally flawed ideas want to wrap themselves in the mantle of the institution's reputation.  If a Harvard professor says its so, well then....

Let me return to Professor Krugman's blog, but let me show how the call for banks to hold more capital is simply a repeat of the call for austerity as it is based on a similarly ill-conceived idea.  

Robert Samuelson tries to minimize the significance of the Reinhart-Rogoff affair; and that, I realized, offers an interesting window into why, in fact, the affair matters so much. 

Samuelson starts by excusing R-R on the grounds that the economic crisis predates their blooper... 

But while R-R obviously had nothing to do with the start of the crisis, the question is how they played into the response. For the remarkable thing about this ongoing slump isn’t so much that we had a financial crisis as the fact that we responded to it, not by applying what macroeconomists thought they had learned, but by repeating all the policy errors of the 1930s....

The same argument could be made about bank capital.

Everyone knows that bank capital is an easily manipulated accounting construct.

Banks can manipulate it by how they reserve for bad debt.  Regulators can manipulate it through regulatory forbearance and allowing banks to use 'extend and pretend' to turn bad debt into zombie loans.  Politicians can manipulate it by pressuring accountants to suspend mark-to-market accounting for opaque, toxic structured finance securities.

Everyone knows that more capital does not mean a bank is safer.

What makes a bank more or less risky is the risk of its on and off balance sheet exposures.

Everyone knows that more capital does not mean a bank is solvent.

Since the beginning of the financial crisis, there have been numerous banks that have shown high capital ratios and been nationalized shortly after passing a solvency focused regulatory stress test.  A prime example of this being Dexia.

Finally, everyone knows that calling for more capital when the banks are hiding massive losses is counter-productive.  The banks need to recognize their losses upfront and then rebuild their book capital.  Recognizing losses first means that banks don't pay the bankers cash bonuses until the bank book capital levels are rebuilt.

By putting increasing book capital ahead of recognizing losses, not only do bankers get paid their cash bonuses, but increasing book capital levels takes precedent over recognizing losses on the bad debt.  The result of this is to repeat Japan's experience and end up with Japan-style economic malaise.

Still, R-R can’t have mattered here, says Samuelson, because politicians were going to do what they were going to do regardless....

Maybe politicians are going to do what they are going to do regardless, however, academics promoting fundamentally flawed ideas are giving them intellectual cover.

For example, let's look at who is championing the idea that banks need to hold more capital.  At the head of the cue we find former and current regulators.  Individuals who had a responsibility for acting before the financial crisis, but failed to take the steps necessary to prevent the financial crisis.

Standard academic obscurity? Reinhart-Rogoff instantly became famous. Reinhart gave star testimony to the Senate Budget Committee on Feb. 9, 2010; the paper was cited everywhere in the spring of 2010.

Sounds a lot like a book written on the need for banks to hold more capital.

OK, so what is the real story here? Austerity policies would probably have proceeded without Reinhart-Rogoff ... But the paper certainly helped sell the policies. 

And anyway, the important story isn’t about the sins of the economists; it’s about our warped economic discourse, in which important people seize on academic work that fits their preconceptions.

Please re-read the highlighted text as Professor Krugman makes an extremely important point about how these professors are warping the economic discourse.  I call this crowding out.

Had these professors not offered their fundamentally flawed ideas, the discussion could have focused on solutions that would have ended our current financial crisis (the Swedish Model) and prevented a future crisis (transparency).

Even if you don’t think Reinhart-Rogoff made much difference to actual policy, the meteoric rise and catastrophic fall of their reputation speaks volumes about why this slump goes on and on.

The slump goes on and on because the academic community continues to provide intellectual cover to policy makers' worse instincts.