Clowns to the Left of Me, Jokers to the Right

It may be premature to write the obituary of health care reform today, but it’s hard to deny that it is bleeding, panting and prone. Who was responsible for what may be its mortal wounds?

It wasn’t Martha Coakley or Scott Brown. It isn’t her fault that she’s an awful candidate, or his fault that he’s a talented one. No, the bulk of the blame belongs to others. With deference to one of our honorees, let’s call these… the worst persons in the world!

This debacle wasn’t all these guys’ doing. But each of them represent in a perfect way the three groups that dimmed the dream of health care for (nearly) all. 

Republicans. Richard Nixon proposed a health care plan that was very similar to the current proposal. Mitt Romney signed a plan in Massachusetts that was also a close analogue, but failed to address costs. A proposal like this one has been well within the Republican mainstream before, yet still Republicans have maintained the fiction that this was a far-out government takeover of health care. It is hard to conceive of how a plan could do more to minimize government intervention and still broaden coverage significantly. 

The Republicans calculated that they had more to gain from a Democratic failure than from a bi-partisan success – and of course, they were right. But if they ever regain a Congressional majority, they will have to live with the culture they have created... drink the soup they've peed on, if you will. They’ve not only proven that obstruction is a winning formula, they have facilitated the means. 60 votes in the Senate, a super-majority that Republicans have not enjoyed since 1922, is now necessary for -- not just controversial -- but any significant bit of business. They might be able to lower taxes and drive us into penury through reconciliation, but anything needed and significant (like controlling Medicare costs) will be out of their reach. We are well on the way to Californiazation: a labyrinth of gridlock with Debt as the Minotaur.

Democratic Centrists. If Max Baucus had not dawdled for months in the foolish hope of getting a Republican to sign on and thus make it a little easier for his centrist buddies to cast a tough vote, this bill would already have been signed. If Lieberman had not killed Medicare expansion, a lot of support from the left would have been saved. If Nelson hadn’t held out for a Nebraska freebie, the Republicans’ best talking point would have been averted. All these guys, but particularly Baucus, share responsibility for the bill’s predicament.

Look, all sides face political pressure. And it is perfectly legitimate for legislators to fight for their interests. But politics is a team sport. It is better to score fewer points on a winning side than be the losing side’s big scorer. These guys thought they were covering their hide, but all of them will be in electoral trouble anyway; it’s impossible to defend a losing bill you voted for. When they get sent home, they won’t be able to say they saved many families from bankruptcy, or got medical care to those who needed it. They lacked circumspection and a sense of proportion about the stakes at play. They valued their place in office more than their place in history.  

Democratic Lefties. Let’s not pretend this bill’s death-knell came solely from the moderates. In fact, some timely reporting seems to indicate that it is the progressives who are setting up the roadblock in Congress. Who are these people led by? Olbermann in the media, Kucinich in Congress, Jane Hamsher in the blogosphere. They decided to draw their line in the sand at a bridge too far: the public option, a proposal that never came close to having 60 votes. Even after the public option was diluted beyond significance, they kept at it as a matter of pride. What was the effect of this? Here, why don’t I show you.
 
Given that so many are dissatisfied with the bill because it doesn’t go far enough, it’s safe to say that if the proposal had maintained the support from the left the bill would enjoy a comfortable plurality of approval in polls and the narrative that it is unpopular would never have taken root. Lefties were angry that centrists were using their leverage in full, and they wanted to have an equivalent amount of leverage. The only way to do this was to convince others (and themselves) that they were willing to walk away too. The natural effect of that was for people, on the left and in the middle, to say… “well, it must not be a very good bill then.”  

I’ve been flabbergasted at the epic ennui that so-called progressives have shown regarding the biggest progressive proposal in decades… the political dream of our lifetimes. They have placed the proposal in a murderous crossfire. Throughout, I’ve been stunned at how difficult it’s been to convince them that our most important priority should be extending coverage to the uninsured, something that I would think would be a basic assumption for them. Instead I’ve heard concern about cost controls being insufficient (as if the status quo were better), concern that the most effective form of cost control is included in the proposal, concern about the Democratic brand, concern about corporate profits, concern about ‘regressive’ taxation (on plans that cost what many would consider a healthy wage.) Really… does any of that stack up against the insuring 30 million people? Does it stack up against letting a whole lot of sick people get medical help? 

I’ll say it again… politics is a team sport. It does not help the progressive cause to destroy a Democratic Presidency that could have (and still might) launch a decades-long majority.

And how has Obama done? I think his strategy was sound, but he is on the verge of a big mistake, if we take his morning talk seriously. Kevin Drum is absolutely right: going back to the Senate would be very foolish. If Obama tries to negotiate a new bill with Snowe and the Republicans, they will do the exact thing they did in 2009. String him along for months but leave him stranded well before a roll call is called. The preferable option is for the House to pass the Senate bill with a reconciliation sidecar. If it can’t do that, then they should pass a (by necessity) more modest bill with reconciliation. Ezra Klein suggest Medicare buy-in, Medicaid expansion, and taxes on the rich to pay for it.

If Obama does choose to go back and grovel to the Republicans, he will have lost this faithful supporter. As the former President Bush once sagely said: "Fool me once, shame on me. Fool me twice… won’t get fooled again."

Fiscal Infantilism

My major beef against the GOP is that it is the major purveyor of fiscal infantilism in our country. What's the standard line?

"Obama has run up a $1.2 trillion deficit! We need to cut spending to bring down that deficit, and cut taxes to get our economy going again."

But won't cutting taxes hurt our deficit?

"No! Cutting taxes pays for itself by spurring the economy."

Even among conservative economists, the only ones who believe this last claim are hacks like Larry Kudlow who are willing to deceive themselves on the historical evidence. Look at this graph:



The Republican tax cuts of the early 80s and early aughts both raised the deficit, even as a percentage of GDP. Reputable conservative economists like Gregory Mankiw readily admit that tax cuts cost money.

But for the sake of argument, let's imagine unicorns exist and tax cuts pay for themselves. Can we balance the budget by spending cuts alone? Well, how much is the deficit projected to be next year again? $1.258 trillion. And how much is discretionary spending for next year, including defense? $1.250 trillion. You could literally cut ALL of government except for Medicare and Social Security and still not be able to balance the budget. (And of course, we know from the current health care debate that Republicans would NEVER cut Medicare spending.)

The smart conservatives all know that they can't make these promises and be fiscally responsible, but they wink at each other and say "hey, tax cuts have been pretty good for getting us elected in the last 30 years. Why change a winning formula?"

Because you can't govern responsibly by getting elected on this platform.

And why do the talking heads, who often profess to be intensely concerned with matters of fiscal rectitude, why are they unable to ask a Republican a tough follow-up when they propose mathematically impossible remedies for our country's problems?

Honest disagreements are possible in politics, but this is surely a question of character. The numbers are inescapable. If a politician is willing to run on the standard Republican platform, he is either a stone-cold idiot or someone who cares more about power than their country.

The Case for Geo-engineering

Nathan Myhrvold appeared last week on Fareed Zakaria's GPS making a compelling argument for geo-engineering in general, and one scheme in particular. I encourage you all to hear him out.

The arguments against geo-engineering tend to fall into three categories. The first is that we don't know whether geo-engineering will work. The second is that it is harmful to even talk about geo-engineering because it might puncture the political will to reduce carbon emissions. Third and finally, geo-engineering is a bad idea because it might bring about unintended side-effects.

Like most advocates of geo-engineering, I would argue that it should be researched further and deployed in conjunction with emission controls, not replacing them. However, in the interest of a fuller examination of our options, I will note that all three arguments could be made just as convincingly against emission controls.

We certainly don't know that an emission control strategy will work -- politically, at least. The IPCC has said that developed nations should reduce carbon emissions by 25-40% come 2020 in order to have a 'reasonable chance' of averting catastrophic global warming. Many now say these targets are too lax, but the Waxman-Markey bill currently being considered in the Congress wouldn't meet them. The bill would reduce U.S. emissions by 17%, and and even that weak bill has little chance of becoming law. With China determined not to jeopardize its growth strategy with verifiable targets, the odds of a global treaty that might head off global warming have to be counted as tiny.

The second argument is easier to dispense with. As Myhrvold himself argues, blaming geo-engineering for reducing the will for carbon controls is like blaming a bypass surgeon for encouraging his patient's snacking. You might also blame carbon controls for discouraging people from taking geo-engineering seriously.

The final argument is more substantive. Many people instinctively recoil at Myhrvold's proposal to reduce solar radiation by pumping sulfur dioxide into the stratosphere via an 18-mile-long hose suspended by a trail of balloons. How could more pollution cure the effects of pollution? But the reason Myhrvold focused on sulfur dioxide is because a natural experiment of this stratagem has already occurred. When Mount Pinatubo erupted in 1991, 20 million tons of sulfur dioxide were injected into the air, lowering temperatures by half a degree. We know the climactic effects of this chemical, and we know its atmospheric effects as well because our power plants already eject it, albeit at far lower altitudes than Myhrvold is proposing. The overall amount of sulfur dioxide believed to be necessary to tame global warming is about one-twentieth of one percent of the amount ejected today by natural and man-made sources, but by expelling it near the arctic and at high altitudes we would be leveraging this chemical for the maximum of its reflective potential.

Are the risks zero? No. We need to research this idea further. But again, the unintended side effects argument could be made against emission controls too. Not even the most optimistic economists think the transition to a non-fossil-fuel future would be free in terms of GDP growth. Particularly in developing countries, GDP has a high corelation with all kinds of mortality data. Sacrificing growth could cost many, many lives.

If we are to be humble about what we don't know, then we should truly be humble about what we don't know. PBS recently had a valuable piece on the environmental effect of mining rare earth compounds in China. Rare earth, a collection of 17 rare elements in the periodic table, is indispensable for many green technologies from car batteries to wind turbines. At the dawn of the internal combustion engine in the 18th century, we had no idea what effect this technology would have on the environment. Can we say for sure that we know all the risks that renewable energy technologies might pose? These wouldn't be discrete acts like putting a hose into the stratosphere, but a million uncontrolled experiments scattered throughout the globe.

Of course, carbon dioxide has effects other than global warming. It also leads to the acidification of the oceans, for example. That is why geo-engineering cannot replace a saner energy policy, but it has to be at its side, preferably before the 'tipping point' effects such as methane release from permafrost and arctic ice melting take their worst toll. At its most basic, geo-engineering is something humble (and cost-effective) like painting your roof white to reflect more sunlight. More ambitious schemes include seeding oceans with iron to encourage plankton growth (the plankton captures CO2) and using solar-powered devices to create water vapor clouds over seas. The governments of developed countries, including our own, need to explore the safety, effectiveness and viability of these technologies.

Finally, I want to make a purposefully provocative comparison. The right-to-life movement tells us that abortion is murder. If they really think it's murder, shouldn't they be the biggest advocates of education about contraceptives? Usually they aren't, because they often believe that sex out of marriage is a sin too, and that education about contraceptives encourages this sin. Of course, education about contraceptives is not promiscuity. It is not even encouraging promiscuity, and might well include messages intended to discourage it. At its worst, education about contraceptives might be seen as encouraging promiscuity. So let's step back: is seeming like you might be encouraging promiscuity really worse than murder? Even if it were a sin, shouldn't you pick a lesser sin if it will diminish a far greater sin? The truth is that the right-to-life movement wants to use abortion as a trojan horse for its ethos. They say abortion is murder, and I'm sure they believe it, but they aren't willing to let go of their worldview in order to act rationally on their convictions.

I fear the same thing is true for not all but many environmentalists. They say the fate of the planet is in the balance, but if it truly is, shouldn't we be exploring every avenue to solve the problem? In the clip, Fareed Zakaria describes their attitude as Calvinist. I'd say they have developed a sort of secular spirituality. In their view, the only thing that will appease Mother Earth is not another sin, but the properly sanctioned sacrifice.

A Third Way in Afghanistan

President Obama is currently pondering the most difficult decision of his young administration: our country’s future direction in Afghanistan. His choice has often been portrayed in the media as binary: should he pursue the counterinsurgency strategy (COIN) proposed by General McChrystal, or should he follow the counter-terrorist strategy advocated by Vice-President Biden?

Media reports indicate that Obama is unsatisfied with the choices he has, and he should be. Both approaches are fatally flawed. Before I say why that is the case, and what a better strategy might be, let’s review why we’re in Afghanistan at all.

What are our interests in Afghanistan? If the Taliban returns to power, it would likely provide a haven for Al Qaeda to launch terrorist attacks against us. There is a legitimate controversy as to how important safe harbor is for an organization like Al Qaeda, with many pointing out that in the past attacks have usually originated in European cities, and that Al Qaeda is now functioning under a ‘cloud’ model that obviates central command. This is true, but it is undeniable that allowing them to reconstitute a sheltered and functioning command and control would be an operational and propaganda victory for them.

If this were the only risk, it would not be sufficient reason for us to stay. The more serious risk we run is that a Taliban victory in Afghanistan might provide moral encouragement, financial assistance and tactical support to an insurgency in Pakistan. Pakistan has a large and capable military, but it is badly infiltrated, and the Pakistani population is the most radicalized in the region. Given that Pakistan has around 50 nuclear weapons, a radical fundamentalist regime next door is simply an unacceptable risk. The claim that is sometimes made about the Iranian leadership – that they are so fanatical they are willing to take risks that threaten their existence – is probably not true about them, but has proved true of the Taliban. In 2001, they threw away power and risked their lives rather than give up their Al Qaeda cohorts; that is a symptom of fanatical – and undeterrable – ideological commitment.

Preventing a Taliban victory, however, is a daunting task. In his recent resignation letter, U.S. Diplomat Matthew Hoh spelled out the difficulties. One doesn’t have to agree with his prescriptions to admire how well he frames the challenge:

If the history of Afghanistan is one great stage play, the United States is no more than a supporting actor, among several previously, in a tragedy that not only pits tribes, valleys, clans, villages and families against one another, but, from at least the end of King Zahir Shah's reign, has violently and savagely pitted the urban, secular, educated and modern of Afghanistan against the rural, religious, illiterate and traditional. It is this latter group that composes and supports the Pashtun insurgency. The Pashtun insurgency, which is composed of multiple, seemingly infinite, local groups, is fed by what is perceived by the Pashtun people as a continued and sustained assault, going back centuries, on Pashtun land, culture, traditions and religion by internal and external enemies. The U.S. and NATO presence and operations in Pashtun valleys and villages, as well as Afghan army and police unites that are led and composed of non-Pashtun soldiers and police, provide an occupation force against which the insurgency is justified. In both RC East and South, I have observed that the bulk of the insurgency fights not for the white banner of the Taliban, but rather against the presence of foreign soldiers and taxes imposed by an unrepresentative government in Kabul.

So when General McChrystal, in his August 30 assessment, writes:

ISAF’s [International Security Assistance Force’s] center of gravity is the will and ability to provide for the needs of the population “by, with, and through” the Afghan government. A foreign army alone cannot beat an insurgency; the insurgency in Afghanistan requires an Afghan solution.

He is giving away the very Achilles heel of the operation. The Afghan forces are as much invaders to the Pashtun tribes as the Americans are. The tribes see them as a force they’ve been fighting for decades: a Kabul-centered government that takes much, imposes much, and gives back nothing. Even if Kabul were squeaky-clean instead corrupt, and duly-elected instead of illegitimate, it would still not command the allegiance of the Pashtun tribes that have resisted their rule for decades. The Pashtun do not like the Taliban either, and they resent their interference – but at least the Taliban is Pashtun. Hoh rightly calls this sentiment ‘Valley-ism.’ The Pashtuns value affiliations of family, tribe, and proximity far more than they feel the bonds of nationality. That at this stage, we do not understand the nature of the challenge ahead of us is uncomfortably reminiscent of Vietnam, where we mistook nationalism for ideological fervor.

Conversely, the problem with a counter-terrorist strategy is not that it is impractical, but that it doesn’t address our interests adequately. Aerial strikes on terrorist targets would make our presence unpopular to the local population, and might hasten a fall of the government. The U.S. might be able to prevent the building of training camps in Afghanistan, but that is all we would prevent. An ideological movement threatening our vital ally, Pakistan, would remain unchecked.

We need to take a step back and ask ourselves: Is the end state we are envisioning – a stable and democratic Afghan government with control over all its land – necessary for the achievements of our goals? The answer is no. We are trying to give Afghanistan something it has never had before, something we do not need in order to defeat the Taliban.

Our recent experience in Iraq might hold some lessons for us. The key to the dramatic turnaround in that country was not the small increase in troops called “the surge,” or the change in strategy to COIN (which since it depends on a change of attitude in the population, would certainly have taken far longer to show such dramatic results.) The reversal was due to the Anbar Awakening: smart U.S. officers on the ground recognized a rift between Al Qaeda and the Sunni insurgency and intelligently exploited it. They backed and coordinated with Sunni brigades called “Sons of Iraq” that employed disaffected former insurgents. This is a strategy that bubbled from the ground up, and it caught everyone by surprise. We didn’t need to defeat our enemies; we could, in effect, hire them.

Perhaps something similar is possible in Afghanistan. Major Jim Gant, a decorated Special Forces officer, was stationed in 2003-2004 with seven other U.S. troops in a small Pashtun village near the Pakistani border. He writes about this experience in a paper, and corroborates much of what Hoh wrote:

Afghan tribes always have and always will resist any type of foreign intervention in their affairs. This includes a central government located in Kabul, which to them is a million miles away from their problems, a million miles away from their security.

But Gant goes on to describe how he developed close relations with the village chieftain, whom he affectionately called "Sitting Bull." He was audacious enough to arm and supply the village's fighters, probably breaking many rules but winning their trust and allegiance and gaining access to valuable intelligence. It is this approach - a tribal engagement strategy - that he advocates for the country as a whole. He calls the fighters Arbakai, a tribal militia that would protect their neighbors from Taliban intimidation. These could be the Afghani equivalent of the “Sons of Iraq,” grass-roots warriors defending their own tribal interests, with the U.S. as their ally – not imposing a central government on them, but giving them what they want: security, their tribal traditions, and the right to be let alone.

I will go farther than Gant does. Instead of envisioning an end state where Kabul dominates all of Afghanistan, we should be striving for Kabul + Largely Autonomous Tribe Lands. The Karzai government would control the heavily populated areas in the east of the country, and as best they could the border areas with Pakistan. They would have nominal sovereignty over their country, as previous Afghani governments have. The Pashtuns would be empowered to defend themselves from the Taliban, but they would largely be free of Kabul too. Provincial government structures would have to be developed in order to resolve inter-tribal conflicts and law-and-order issues; largely, governance would come from nearby.

Obviously, bringing about this end state is an extraordinarily difficult task. We would need a lot of men like Gant: smart, highly trained, with a ravenous cross-cultural appetite and a keen emotional intelligence. These people would have to develop close relationships on the ground and would need to attain a granular view of local politics. It would be a war won not so much by force as by micro-diplomacy. Despite the complexity of the task, this might be the only way to achieve our objectives. It is foolish to fight a war that requires winning the allegiance of an inherently conservative people while also attempting to re-engineer their society. As Gant writes:

We will be totally unable to protect the “civilians” in the rural areas of Afghanistan until we partner with the tribes for the long haul. Their tribal systems have been there for centuries and will be there for many more. Why should we fight against not only what they have been accustomed to for centuries, but what works for them? They will not change their tribal ways. And why should they?

Beyond Theory

In this recent op-ed David Brooks contrasts Bentham, an arrogant central planner, with Hume, a humbler fellow who prefers decentralized, market-based solutions to problems.

I agree that there are two kinds of people in the world, but I don't divide them this way: my two groups are pragmatists and ideologues. One group works from the evidence to the solution; the other works from the solution to the evidence.

At this point in history, we can safely say that we know these things for sure: pure, unfettered markets do not work and central command economies do not work. The ideal is somewhere in the middle; we need to sort out when it is the right time to to intervene and regulate, and when we need to let the market do its magic. Who do we trust to do that? Who can look at the evidence dispassionately, and make decisions based on facts instead of predilections?

If I know nothing else about them, I'll go with the person who doesn't enter the room trumpeting his principles.

In Angels in America, Tony Kushner has the world's oldest living Bolshevik plaintively ask "how are we to proceed without theory?" That same question seems to be stirring in the hearts of many conservatives today.

Pssst! My Negotiating Position Is Not My Real Position

I know I’m not supposed to say this. I’m supposed to say “the public option is non-negotiable! No public option, no health reform!”

I realize why I’m not supposed to say what I’m going to say. The people who are willing to walk away from a deal are the ones who have the negotiating leverage. I know this. But even though I really want to see the health care reform bill include the public option, I have this thing… I can’t help but blurt out the truth sometimes. And the truth is I wouldn’t dream of letting health care reform die just because public option wasn’t included. Why? Well, isn’t it obvious?

What would happen if health care reform failed?

• Barack Obama’s presidency would be crippled. Any hopes of passing cap-and-trade, financial reform, or an immigration bill on our terms would be dimmed dramatically.


• The Democrats would likely be punished in 2010. The last time a popular Democratic President failed to pass health care reform the Dems lost 54 seats in the House. A swing of that magnitude would give the Republicans the lower chamber again.


• Health insurance companies would be able to continue to dump sick patients from their rosters.


• Coverage would continue to be out of reach for those with prior conditions.


• Lifetime caps and high out-of-pocket requirements would ensure that the endless march of healthcare bankruptcies continued.


• We likely would not see another attempt to reform health care for a generation, if ever. 18,000 people die from lack of health coverage every year; extend that number over two or three decades and perhaps half a million people might die unnecessarily if we fail to gain universal coverage.

I’m not willing to pay this price. All these items could be avoided and reversed, even with a plan that did not contain a public option. Would a true progressive put an ideal bill above the pressing interests of 47 million uninsured? No, of course not. But we have to say we will!

Pretending that we are willing to kill health reform forces us to use unconvincing arguments sometimes. For instance, we say that if we don’t get the bill right this time, we’ll never get it right. This is baloney. Comprehensive health reform is extremely hard to pass: Truman, Johnson, Carter, and Clinton all failed at this challenge. There’s simply no evidence that tweaking health programs once they are law is nearly as difficult. S-CHIP has been repeatedly amplified and refocused, Medicare grew a prescription benefit, and Medicaid has been tweaked many times over the years, sometimes for the better and sometimes for the worse.

We also say that if we don’t pass the public option health care expenses will grow out of control and the Dems will be blamed for it, allowing the Republicans to roll back our reforms. Of course, the other side will try to blame us for growing expenses (and they will likely grow anyway, with or without the public option.) But what would happen with no bill at all? Many significant measures that would lower cost and improve quality – like comparative effectiveness research, more power to MedPAC, and health care IT expansion – would be lost. As for the idea that the Republicans would roll back universal coverage, I say this: Will. Never. Happen. No industrialized nation that has achieved universal coverage has ever gone back. Even Margaret Thatcher, a political giant who privatized every damn thing she touched, didn’t dare touch the British health service.

We have to over-sell the public option. CBO says it will save the government $150 billion over 10 years; a whole lot of money, but we have to pretend the fate of the trillion dollar plan depends on these savings. And we have to exaggerate the scope, even though it’s likely that only 10 million people will be covered by the public option.

Finally, in order to make sure that Obama puts maximum pressure on the Senate centrists, we have to pretend that he has the magical ability to buckle Senators from states where he lost by 15 points. Even though we’re a ways from getting even 50 votes in the Senate, we have to pretend that 60 is a cinch. As they say, the squeaky wheel gets the grease.

I know I sound like I’m being ironic. The thing is I’m not. Yes, the public option is an uphill battle, but it’s definitely not a lost cause. That’s why Steve Pearlstein is wrong in saying we should give it up. Intrade lists the public option’s odds at 35%. We are still in the game, and not letting on to our bottom line is a big part of the game.

So maybe someone in comments is going to “disagree” with me. You’re going to call me a sell-out and a weak-kneed accommodator. You’re going to say of course we should ditch the health care bill if it doesn’t have the public option… it would be worthless without it! That's exactly what you should say, thank you. Sorry we “disagree” (wink, wink.)

Others of you (not many I hope) are going to share my lack of discipline and surfeit of honesty and tell me you agree with me. All I can say is… shame on you.

Okay, maybe now I’m being ironic.

For Übergeeks Only: Why Krugman Is Wrong

A couple of days ago, Paul Krugman wrote a widely cited post where he argued that the Geithner plan would amount to a huge subsidy for banks. The taxpayers, he fretted, would once again be taken to the cleaners. To fill in some background: in the Geithner plan Treasury funds are combined 1:1 with private equity; together they go to the FDIC and obtain a non-recourse loan six times greater than the original principal. Private investors decide how to invest while the Treasury piggy-backs on their expertise, splitting the proceeds with them.

Krugman is skeptical. The fact that the loans are non-recourse, he writes, would mean that investors would likely take greater risks since their losses are capped, costing the taxpayer dearly. I know... he won a Nobel Prize and I didn't. But he's wrong and I'm going to prove it.

Here's the example Krugman cites:

Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.

But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?

The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.

Here is what he means. A bid of $130.50 makes the average outcome of the scenarios $0. That is the breakeven point... a higher bid than that will, on average, result in a loss:
In another post, he explains that "two-state numerical examples" are the natural way to think about these things. Really? Just out of curiousity, what would happen if we went to a three-state numerical example?
Huh. When you add a middle scenario, all of a sudden the breakeven point has gone down to $116.28. Of course, in real life outcomes don't isolate themselves into two faraway islands. What if we kept on adding scenarios...
Wow. It looks like if we modelled this more like real life the overbidding Krugman writes about diminishes. If there were an infinite number of scenarios between $50 and $150, as there would be in real life, the degree of overbidding might even be reduced to single digits.

Let's also ask ourselves: is the spread of uncertainty likely to be as wide as Krugman's example? Think about it. There's a 3x spread between the high value and the low value. This would be like saying that a security with a face value of a dollar could as easily cost 25 cents as 75 cents. Remember that investors will have information about the payment history and location and credit history of the borrower, and remember that they have a wealth of prior experience on how similar borrowers have performed before. Isn't it likely they will be able to make far better projections than that? What if we narrowed the scope of uncertainty?
That makes a huge difference. Now the rational investor is only overbidding by just under 5%. But okay, let's say we overshot when we narrowed the spread of the scenarios. After all, no one can really predict economic performance, and that will certainly be a significant variable. Let's widen the scenarios a little to say... 40% on either side. But let's not pretend that there's an equal chance of getting extreme scenarios as opposed to the middle scenarios. Let's weigh the scenarios on a bell-shaped curve, giving more weight to the likelier middle scenarios, and less weight to the unlikelier extreme scenarios:
Still, a rational investor is only overbidding by around 5%. But I hear you say: 5% of a trillion bucks is an awful lot of money. It sure is. But there are other factors we have not considered yet.

First of all, the FDIC loans are low-interest... but they're not no-interest. The government will be making some money on the loans that do happen to perform.

But more importantly, there is a fallacy in our calculations. We're pretending investors are eager to risk capital just for the sake of breaking even. That's crazy. On the day the Geithner plan was rolled out, Bill Gross of PIMCO went on CNBC saying he expected returns in the "low teens." For any investment where the entirety of your capital is at risk, that is the minimum you should expect. So the bids are going to be lower than the breakeven price; they need to factor in their profit. Notice also that profit expectations increase as the range of uncertainty we mentioned above, the risk, increases.

Nor should we forget that it's not cheap to pore over loan tapes and make calculations that are far, far more sophisticated than the ones we've just done. Expenses will be at least 1%... probably more. Lower the bid by that amount. (Meanwhile, our government will have no such expenses.)

Together, these underbidding effects will dwarf any overbidding due to the capped losses. While there is no guarantee that the U.S. will not lose money on this deal, it is far likelier that we will profit. As many economists before, Prof. Krugman has let his theory come untethered from reality.

Update: I forgot to decrease the cap amount as the bid decreases! Still, that doesn't change the numbers too much. In the final case, I still have a number just slightly above 5%. I'll update with correct numbers later. 1:32PM: The numbers are now corrected.