Folly and "Financial Reform," Part II

In Paul Krugman's column on "financial reform," he makes it sound so simple. Just put, smart, "well-meaning" regulators in power, and they will make sure that the financial system will work just fine.

Unfortunately, while Krugman understands the technical jargon about finance, he really does not comprehend the economics behind it. According to Krugman, government regulators can pick "winners" just as well as anyone else can do, and since capital itself, economically speaking, is homogeneous, well it is pretty easy to run an economy. Just let the regulators decide where the loans shall go, and there won't be any risk, and the economy will work like a clock.

This is fantasy. If government regulators really could pick winners, as Krugman seems to think, then people that wise immediately would be hired by investment firms -- at many times their government salaries -- and lead Wall Street firms into investment bliss. In truth, reality is much more complicated.

If the world Krugman still champions were in existence now, I would not be writing this piece, as laptops -- if they existed at all -- would be much more primitive than they are now. Forget about the Internet, since copper wire still would be transporting telephone calls, and the Internet as we know it could not exist under such technology.

Television would continue to be the dreadful fare of a few network stations, Dan Rather still would be on the air (since there would have been no bloggers to expose his dishonest use of forged documents in a diatribe against President George W. Bush), and the only way to be able to read Krugman would be if one purchased a paper edition of the New York Times. That is because the "shadow" system Krugman so despises, was the system that financed most of the high-technology ventures that have become an integral part of our lives.

Someone like Krugman cannot understand this because in his world, economic outcomes depend only upon how much money the government is willing to print. Whether or not the financial system operated under 1930s rules or if investors were free to pursue the new technologies would lead to exactly the same outcomes, at least where what was available to consumers is concerned.

In other words, Krugman has no concept of the Law of Cause and Effect. To him, the effect always is the same, economically speaking. However, to Austrian economists, the Law of Cause and Effect is front-and-center in understanding economic outcomes.

Austrians understand that the banking system Krugman so praises could not and would not have financed what turned out to be a massive economic recovery during the 1980s. That role was left to the "shadow" system.

Now, most of the deregulation initiatives of the 1980s and 1990s really was re-regulation, and the system became increasingly skewed, as politicians sought to maximize political contributions coming from the financial sector. Unwise laws like Sarbanes-Oxley limited possibilities of profit within our borders, so banks and brokerage houses turned to other means to make money.

While it is easy to decry a lack of oversight when the financial system went ga-ga over what turned out to be toxic mortgage securities, in hindsight, we realize that had the politicians not deliberately shackled the productive U.S. economy, perhaps banks and brokerage houses might have pursued more sound "investments" than pyramiding funds atop mortgage securities that turned out to be worthless.

Furthermore, Krugman forgets that the loose credit policies of the Federal Reserve System helped to trigger reckless lending and touched off an unsustainable boom. (Krugman does not believe booms are unsustainable. He just believes that if a boom slows down, government needs to print lots of money to keep the party going.)

Now, I agree with Krugman that the banks and brokerage houses were irresponsible, but one does not forget that people who believe that the government "has their backs" are going to be more reckless than people who understand that if they fail, they have to pick up their own pieces. Krugman never seems to fathom that the moral hazard created by the government backstops ultimately set the stage for this disaster. Nor is he ever going to change his tune; it's his story and he is sticking with it. I'll stick by my account.