Friday, May 18, 2012

Krugman Gets Something Right then Shows His Ignorance of Finance

Paul Krugman correctly writes:

Is it possible that I have misjudged Mitt Romney? 
My take has always been that he’s a smart guy who also happens to be both ambitious and completely amoral; he decided that his career can best be advanced by pandering to the crazies of the right, and will say anything to that end. 
More and more, however, he has been coming out with statements suggesting that he is, in fact, a dangerous fool.
But then, to prove his point, Krugman displays his ignorance of finance. He writes:

The latest [from Romney] JPMorgan’s loss was no biggie:  
This was a loss to shareholders and owners of JPMorgan and that’s the way America works Some people experienced a loss in this case because of a bad decision. By the way, there was someone who made a gain. The $2 billion JPMorgan lost someone else gained.
Hey, when Lehman Brothers lost a lot of money, that was money someone else gained. No problem, right?
This was a loss to shareholders and owners of JPMorgan and that’s the way America works Some people experienced a loss in this case because of a bad decision. By the way, there was someone who made a gain. The $2 billion JPMorgan lost someone else gained.
Romney is actually correct here. Because of the financial instruments used in the JPM trade (the best way to think about it is that it was a bet) , there is a winner and loser.

However, that wasn't the case with Lehman Brothers. There was real net loss to the system. Think of it this way. I Lehman owed you money and they didn't pay you, you lost. But Lehman also lost because no one wanted to trade with Lehman because they didn't pay you. You lost, Lehman lost. (Note: It's possible some who shorted Lehman stock made money, but this is not integral to Lehman going down., Lehman going down happened at the debt level, where their were losers far beyond Lehman)

The JPM trade is completely different in that a loss by JPM means a direct gain to the party on the other side of the trade.

Understanding of finance Romney +1, Krugman -1


5 comments:

  1. lehman isn't a person, though, unlike those shareholders and owners referenced in his statement.

    the people that were behind that incorporated pile of cash (or, database of digits, if you prefer) all profited in advance by "earning" wages and commissions from lehman.

    had that money not been borrowed, perhaps lehman would have closed up shop sooner -- being in no state to repay it, anyway, as was discovered -- and it follows from this that those employees would not have gotten paid.

    surely jpmorgan the entity has likewise lost: the owners and shareholders are doing business with it, just as the lenders to lehman did business with lehman, and these too have likely now lost much confidence in jpmorgan as a vehicle to build wealth.

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  2. How does the trade that killed Leham different from the one that JP Morgan made. I don't understand what was traded...

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  3. "Can Romney really not understand that key financial institutions are different from any old business — that when they fail they can wreak havoc?" (Krugman)

    It's a non sequitur to claim that some people losing and some people winning necessarily means that "havoc" isn't wrecked upon those who made the losses. i.e. Romney can be right and can still agree that when the key financial institutions failed, they wrecked havoc.

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  4. Unfortunately, Krugman's main point remains valid: a financial institution that receives deposit from the public may be in a particularly vulnerable situation if their bets go bad.

    If depositors start withdrawing their money from the bank, there in turn may lead to another government bailout given that JPM is "too big to fail".

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    Replies
    1. Krugman's point is about losses matching gains. That occurred in the JPM trade but didn't in the Lehman situation. You are as confused as Krugman (Maybe you are Krugman)

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