Paul Krugman misses Bernanke's role in disrupting the default/insolvency cycle

In his NY Times blog, Professor Paul Krugman tries to understand the rage directed at Ben Bernanke for lowering interest rates as the economic textbooks say he should be doing during a time of high unemployment and low growth.

Professor Krugman specifically cites Paul Singer's observation that Bernanke's policies are destroying the very fabric of society.

What Professor Krugman misses, and his miss is not at all surprising given that macro economic models do not include the financial sector, is Bernanke's role in disrupting the default/insolvency cycle.

What Mr. Singer and others who have expressed rage at Mr. Bernanke's policies realize is his policies are pushing the cost of the excess debt in the financial system onto savers and through austerity undermining the social contract.

Regular readers know that modern banks are designed to absorb the losses on the excess debt in the financial system and protect the real economy and social contract.  Banks provide this protection because absorbing the losses means that capital that is needed for reinvestment, growth and supporting the social contract is not diverted to making debt service payments on the excess debt.

But wait a second, isn't all Chairman Bernanke doing is lowering rates as the economic textbook suggests?

Chairman Bernanke is doing one more thing.  He is covering up the losses that are currently on and off the bank balance sheets.

Everyone knows that these losses exist, but Chairman Bernanke pretends they don't.

Because he pretends these losses don't exist and signs off on the Fed's bank solvency stress tests, bankers are able to receive enormous cash bonuses that would otherwise be used to rebuild bank book capital levels.

Because he pretends these losses don't exist, firms that should have gone out of business are allowed to continue operating.  This in turn distorts the economic system.

Everyone knows why Chairman Bernanke and the financial regulators wouldn't want the true magnitude of the losses to be known today.  They are fearful of that a second Great Depression could occur.

What Chairman Bernanke and his fellow financial regulators fail to consider is that everyone already knows there are tremendous losses buried in the global financial system.

It did not escape the market's attention that Spain just announced that over 15% of the debt on its banks' balance sheets had to be restructured in the last year.

It did not escape the market's attention that recently Cyprus banks had losses exceeding 20% of their asset value.

What has also not escaped the market's attention is that banks are designed to absorb these losses and rebuild their book capital levels over several years through retention of future earnings.

The source of rage that individuals like Paul Singer feel is that Chairman Bernanke and the financial regulators who did not see the financial crisis coming are now treating someone who did see the financial crisis coming like a child.

I am reminded of that famous movie line: "you couldn't handle the truth".

Hello, the guys who predicted this crisis know that the losses are huge.  They just don't have precise figures for how large the losses are.

They also know something about how the financial system operates.

What their rage is saying is that the financial system is perfectly capable of absorbing the losses that the Chairman and the rest of the financial regulators are hiding.