Folly and "Financial Reform", Part I

In my review in the Freeman of Paul Krugman's The Return of Depression Economics and the Crisis of 2008 (a book that I am requiring for my MBA students this spring) I noted that he made some insightful observations and comments. However, I continued, he then draws all of the wrong conclusions:

...alas, in the end Krugman resorts to the arguments of the great economic cranks of history, from Silvio Gesell to John Maynard Keynes. He’s like the mechanic who expertly describes a problem with your fuel pump—then insists your car needs more gas. If the tank is full, he tells you to attach an auxiliary tank.

In other words, Krugman is still the one-trick pony featured in the Times. Whatever the problem, his solution is always the same: inflation.

Thus it is today with his column on financial reform.Krugman correctly notes that the financial sector took risks that clearly were out-of-bounds, yet they also understood that the government had their backs. All of us can agree on that point, but the next question is where we part: Now that the financial meltdown has happened, what should we do about it?

Austrian economists like me believe that we need to move entirely away from a financial sector backed up by the printing presses of the U.S. Government and the monetary manipulations of the Federal Reserve System. Such a system always is doomed to failure because the symbiotic relationship between the financial sector and government is inevitable when government agents can descend on that sector and overnight change outcomes.

(The predations of Elliot Spitzer and Rudy Giuliani come to mind. While both men were effusively praised by Krugman's NYT employer, Wall Street got the message and gave both men massive amounts of campaign contributions. Like Willie Sutton, politicians know they can raid Wall Street because "that's where the money is.")

Krugman, on the other hand, approaches financial regulation from this point: Democrats always good, Republicans always bad. Democrats want wise regulation, Republicans want wild speculation. Now, that is something I expect to hear from political hacks or from Keith Olbermann, not to mention the editorial writers and columnists at the NYT.

I don't expect a decorated economist like Krugman to give in to this simplistic hackdom, and that is what he is doing, like it or not. Furthermore, he gives a skewed history of the rise of what he and others call the "shadow banking system."

In Krugman's history, the tightly-regulated banking system was almost impervious to failure because regulators kept it from going after Big Risks. Unfortunately, those bad free-market ideologues both created a shadow system and then bamboozled the Wise Government to deregulate the banking system, ultimately leading to the present crisis. That is a history that plays well to both his audience and the current crop of politicians in power.

As I said before, I expect to hear such nonsense from the Usual Suspects, just as I expect Ann Coulter to claim that Barack Obama is not pursuing Big, Bad Muslims around the globe with enough ferocity (and, thus, adding further to our government's financial bankruptcy). However, as economists have noted for decades, the real story of regulation is much more nuanced and requires for people not to give into partisan diatribes.

What Krugman does not tell us is that by 1980, the small, wonderful banking system was in crisis in no small part because of the regulation Krugman praises. Regulators operate according to a set of incentives in which they receive no credit for "picking winners" but are in hot water if they allow actions that result in failure. Therefore, the default for regulators always will be "no."

Ever hear of MCI? Of Borders Bookstore? Of McCaw (now AT&T) Cellular? Of CNN? Of fiber-optics and a thousand other high-technology initiatives? The reason you have heard of them has been that "shadow banking system" that Krugman condemns. The heavily-regulated banking system would not touch them because these were new ventures that were outside of the usual kinds of things (like government bonds) that banks were permitted to help finance.

Like the entrepreneurs in Elizabethan England who set up shop outside London (because the Queen had granted monopolies in that city to her favored people), something noted by economists Robert Ekelund and Robert Tollison in their book Politicized Economies, the shadow financial system grew precisely because it allowed investors to pursue profitable opportunities that the regulated banking system could not.

Furthermore, the "tightly-regulated" banking system, which really was more of a regulated cartel, was losing capital. Part of the regulatory deal was that government would limit the risk the system could take, but it also would place ceilings on interest rates the banks could offer. At a time when inflation was in double-digits, but banks only could pay depositors something in the range of 6 percent, people flocked to money market accounts being offered by financial entrepreneurs that were relatively safe but also paid higher interest rates.

Like the entrepreneurs who broke down the Mercantilist regulatory system of post-Renaissance England simply by locating elsewhere, the financial entrepreneurs like Michael Milken helped to finance what would be our economic future for two decades. Of course, the established financial firms on Wall Street that were being left out of the action did not like upstarts like Milken, and so Rudy Giuliani did their dirty work, urged on by the NY Times and others.

(By the way, Milken was a liberal Democrat and hardly falls into the category of the "free-market, Republican ideologue" so demonized by Krugman and others. In other words, Milken did not fit the stock profile, but nonetheless was pushed into that false category anyway.)

The background being set, in Part II, I will look at Krugman's current statements and point out why they are wildly untrue and misleading.