March 24 (Bloomberg) -- Treasury Secretary Timothy Geithner has a good chance of succeeding with his plan to cleanse banks of toxic assets, says A. Michael Spence, co-winner of the 2001 Nobel Prize in economics. Paul Krugman, the newest laureate, is so sure Geithner will fail that he’s full of “despair.”

Even winners of the highest awards in economics can’t always be right. Which prediction proves correct depends in part on whether private investors can be enticed to bid on as much as $1 trillion of illiquid loans and securities that banks are now stuck with.

“This program is crucially dependent on the private sector as participants and price setters,” said Spence, 65, who shared the Nobel Prize with George Akerlof and Joseph Stiglitz for a theory that found some government intervention can make markets more efficient. “It could work,” Spence said in a telephone interview yesterday.

That’s not an opinion shared by 2008 Nobel laureate Krugman. “The real problem with this plan is that it won’t work,” Krugman, 56, said in his New York Times opinion column yesterday.

Geithner appears to be going back to the “cash for trash” approach of his predecessor as Treasury Secretary, Henry Paulson, Krugman said. “This is more than disappointing. In fact, it fills me with a sense of despair.”

Krugman’s Advice

Instead of financing the purchase of illiquid assets, the government should guarantee many bank debts, take control of “insolvent” firms and clean up their books, similar to what Sweden did in the 1990s, Krugman said.

While Spence, a Stanford University professor and former business-school dean, has more confidence in Geithner, even he isn’t positive the Treasury secretary can pull it off.

The Treasury plan “is a little complex to implement,” Spence said. “I assume the Treasury has done its homework, and has people lined up” to commit private capital to Geithner’s public-private partnerships, he said.

Stiglitz, speaking at a conference in Hong Kong today, said the plan “risks a major increase in our national debt.”

“You can take the bad assets off the banks, but where are they going to go?” said Stiglitz, 66, who served as chairman of former President Bill Clinton’s Council of Economic Advisers. “The one place for them to go is to the taxpayers.”

Congressional Scrutiny

A crucial question is whether private investors can stomach potential threats and scrutiny from Congress, whose move last week toward taxing employee bonuses may drive bidders away, said Carnegie Mellon University professor Allan Meltzer, 81, author of a history of the Federal Reserve.

Geithner’s plan “will certainly help,” Meltzer, 1997 winner of New York University’s Money Marketeers Distinguished Achievement Award, said in a telephone interview yesterday. At the same time, “the Congress has really clobbered the rule of law, and that has terrible implications for the future,” he said.

The plan is aimed at financing $500 billion to $1 trillion in purchases of illiquid real-estate assets, using $75 billion to $100 billion of the Treasury’s remaining bank-rescue funds. It also will rely on Fed financing and guarantees from the Federal Deposit Insurance Corp.

Treasury left some details to be announced later, including the precise amounts investors would be required to put up for each type of asset and the terms of loans that the Fed would provide.

Lawrence Summers, 54, a former Treasury secretary and head of Obama’s National Economic Council, said in a Bloomberg Television interview yesterday that he was “surprised” by the negative comments from Krugman.

Summers, no Nobel laureate but the 1993 winner of the John Bates Clark medal as outstanding U.S. economist under 40, said he doesn’t know of “any economist who doesn’t believe that better-functioning capital markets, on which assets can be traded, are a good idea.”

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net. Vivien Lou Chen in Phoenix at vchen1@bloomberg.net.

Last Updated: March 24, 2009 09:26 EDT