Commentary

Krugman or Paulson: Who You Gonna Bet On?


History will show that the week before the nation's 234th birthday, Paul Krugman, Nobel Laureate and professor of economics at Princeton University, went all in on Keynesian orthodoxy. To regular readers of his column in The New York Times, this was not a surprise. Since the financial crisis began, Krugman has been adamant that the federal government must fearlessly run up deficits to compensate for weak private spending and keep the U.S. economy from death-spiraling into deflation.

Now his warnings have taken on an even more dire tone. The threat is not merely the dreaded "double dip." If the leaders of the developed world hold to pledges they made at the G-20 summit in Toronto and cut government spending, Krugman argues, we face nothing less than a "third depression"—perhaps not as singularly devastating as the Great Depression, which ripped the U.S. economy in half, but comparable to the Long Depression that followed the Panic of 1873, a grinding period of chronic social need and dissension.

If that makes you want to head for the hills with your shotgun and turnip seeds, consider another view, expressed the week prior at the London School of Economics. The speaker was not a decorated academic with visions of 1873, he was a profit seeker, pure and simple: John Paulson, the hedge-fund manager on whose behalf Goldman Sachs (GS) cooked up those killer collateralized debt obligations designed to pay off handsomely in the event of a housing crash. He was right about that one, you'll recall.

"We're in the middle of a sustained recovery in the U.S.," Paulson declared in London. "The risk of a double dip is less than 10 percent." The housing market is now, he says, an attractive buying opportunity. "It's the best time to buy a house in America," he said. "California has been a leading indicator of the housing market, and it turned positive seven months ago. I think we're about to turn a corner."

No mention of a third depression.

Paulson's bullishness is not new. Last spring, when Krugman was arguing that some major U.S. banks ought to be nationalized, wiping out equity holders, Paulson was busy building a massive stake in Bank of America. He and Krugman may not have disagreed about the fundamental health of the banking business—they just disagreed about what it meant. Paulson wasn't buying banks because he liked their second-lien books; instead, he had grasped that the Swedish-style takeover Krugman advocated was not going to happen, and that a tacit federal backstopping of the banking industry took most of the risk out of going long.

With the American taxpayer covering his downside, investing in U.S. financial institutions was easy pickings. Paulson's latest 13f filing with the Securities & Exchange Commission, which records his holdings as of Mar. 31, indicates nearly $2.995 billion of Bank of America common stock and $2.052 billion of Citigroup (C) common. Despite healthy advances from their spring 2009 lows, banks may have more room to run, particularly if Paulson is correct in the estimate he made to investors, according to The Wall Street Journal, that housing prices will rise as much as 10 percent next year.

Since his initial forays in banks, Paulson has ventured into riskier assets like casino stocks and vacant residential land in the utterly busted Florida and Southern California markets. As a private hedge fund manager, Paulson is not obliged to provide a complete picture of his investments; long positions could be hedged with shorts and derivatives that he does not have to divulge. But nothing in either his statements or reports about what he's buying suggests he is anything less than upbeat about the economy right now.

Some positive currents seem to be gathering force beneath the choppy stock market. U.S. credit-rating upgrades on corporate bonds exceeded downgrades this quarter for the first time since before markets froze, according to Bloomberg News. "I do see more upgrades coming," says Ann Benjamin, chief investment officer of leveraged asset management strategies at New York-based Neuberger Berman, where she helps oversee $7.5 billion of high-yield bonds and $5 billion of loans. "There's plenty of good companies out there that may be misrated."

Krugman, by contrast, sees darker forces at work. He argues that the market has already ratified his belief that fiscal tightening will smother the recovery, pointing to widening bond spreads in Greece and Ireland, where huge cuts loom. About Ireland, Krugman recently wrote on his Times blog, "All that savage austerity was supposed to bring rewards...But the reality is that nothing of the sort has taken place: virtuous, suffering Ireland is gaining nothing." The markets have been kinder to Spain, he says, because leaders there have cut less.

The heart of the matter, for Krugman, is unemployment. As long as it remains at such elevated levels, he says, more and more people remain out of work for so long they become unfit to hold jobs.

It's hard not to marvel at Krugman's conviction about how all the pieces fit together, why it's essential to mankind that Germany start spending and China let the value of its currency appreciate. If the world economy had a cockpit, Krugman exudes the confidence of a man who could climb in there, flip all the right switches, and get this sucker airborne.

Paulson has a simpler view: Americans are starting to spend again, in ways not terribly dissimilar to the ways we did before, buying suburban homes and stuffing our Social Security checks into slot machines. There are pitfalls. As we work our way back to the old normal and demand picks up, the years of superlow interest rates will come back to smack us, fueling inflation that Paulson sees possibly reaching into the double digits within a few years. That's why, in addition to Florida property, Paulson is heavily invested in gold.

As Gregory Zuckerman described in The Greatest Trade Ever, Paulson rose from obscurity by exploiting the age-old tendency of investors in flush times to blithely assume risks they don't understand, like buying the other side of his bespoke CDOs. Now he has flipped, betting that investors are so gun-shy they can't quantify the potential for upside. Recent tremors in the stock market bring flashbacks of fall 2008 and the nerve-racking question: Is this the big one?

The debate over the economy can be thought of as a trade—Paulson taking one side, Krugman the other. Paulson's got real money on the table, but for both men, the main risk is reputational. Is Paulson another Wall Street one-hit wonder? Is Krugman another too-smart-for-his-own-good academic with no feel for animal spirits? Paulson may have an edge because he is just playing the market. Krugman is playing history, which is quite a bit trickier.

Additional reporting by John Glover and Sapna Maheshwari

Lindgren is an Executive Editor for Bloomberg Businessweek.

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