Paul Krugman: reasons current policies to end financial crisis has failed are obvious

On his NY Times blog, Paul Krugman attempts to explain why it was predictable that the policies applied to end the bank solvency led financial crisis would not succeed and why it is no mystery what must be done to end the crisis.

Regular readers know that the Nobel-prize winning economics professor is on the right track when he says it was predictable before the policies were implemented that they would fail [your humble blogger predicted it] and why it it is no mystery what must be done to end the crisis [your humble blogger has been saying it publicly since the beginning of the crisis].

However, like all economists, he fails to consider, or maybe it is understand, that there is an X-factor that explains why the policies implemented would fail and why his choice of policies to end the financial crisis would have failed also.

The X-factor is the banking system and the excess debt in the financial system it is designed to absorb the losses on.

It is a very bold statement to say economists fail to consider or maybe understand the role of the banks and why they are an X-factor.

Why do I make it?

No less an authority on economics than Nobel-prize winning economist Joseph Stiglitz observed that prior to the financial crisis economic models left out the banking system in its entirety.  The banking system was seen as moving money from your left to right pocket and therefore could be ignored.

The conclusion from this statement is if the policies you recommend when the banking system is ignored are the same policies you recommend after we discover that the banking system cannot be ignored, there is little reason to believe your policies are right.

Chris Giles of the FT reports that central bankers are worried that they are “flying blind”; he quotes Lorenzo Bibi-Smaghi, formerly of the ECB governing board, saying “We don’t fully understand what is happening in advanced economies.” 

Um, guys, that’s because you don’t want to understand.

Professor Krugman makes an excellent point about the desire of central bankers, policy makers and economists not wanting to understand what is happening.

I have explored on this blog a number of different reasons they might not want to understand or worse, understand, but chose to adopt policies that don't reflect this understanding.

Nothing about our current situation, except maybe the absence of outright deflation, is at all surprising or mysterious. 

We had a huge financial crisis, and the combination of a housing bust (on both sides of the Atlantic) and an overhang of household debt (also on both sides) has acted as a drag on private demand.

Here is where a discussion of the banks and how they are suppose to absorb the losses on the excess debt in the financial system is suppose to come in.

Monetary policy quickly found itself up against the zero lower bound, while fiscal policy, after providing some stimulus, soon turned strongly contractionary....

Here is where Professor Krugman pushes his solution of more fiscal stimulus needed.

Unfortunately, by not dealing with the excess debt in the financial system, this additional fiscal stimulus would also not solve the problem.  Put simply, the fiscal stimulus would be swallowed by the debt burden that the excess debt places on the real economy.

We saw this with the original fiscal stimulus at the beginning of the Obama administration and we have seen this repeatedly in Japan.

But many central bankers and other officials chose to ignore all that and place their faith in the confidence fairy instead. 

So now that it has all gone wrong, they throw up their hands and say that it’s a mystery — how could this happen? 

No mystery, guys; you messed up.

The same conclusion would hold had Professor Krugman's solution been followed in the absence of requiring the banks to absorb the losses on the excess debt in the financial system.

However, if the banks were required to fulfill the function that they are designed for, which is absorbing the losses on the excess debt in the financial system, then Professor Krugman's solution would in fact see the results he anticipates.