What Constitutes "Financial Reform"?

In a recent column, Paul Krugman raises a very important issue, and while he goes through his usual partisan attacks, nonetheless I think this is something that should be up for discussion. What actually constitutes legitimate "financial reform"? Indeed, what does?

First, everyone is in agreement that Wall Street, not to mention financial houses across the globe, are in big trouble. Why? The fundamental reason is that they throw trillions of dollars into investments that ultimately could not give the anticipated returns and, in fact, many of those investments completely went bust.

Second, I think most people are in agreement that we cannot go back to business as usual, or the arrangement that gave us the actions by bankers and others in the financial world that brought about the meltdown and subsequent depression. Thus, the question is not if we should have reform, but rather what kind of reform should it be.

That being said, one can be sure that Krugman and the Austrians (including me) are going to be on opposite sides of the issue. Krugman wishes to bring back what Austrians refer to as banking cartel that was established during the New Deal. Beyond that, we also are in major disagreement about the role of the Federal Reserve System in financial reform. (OK, I'll be honest. We Austrians want the Fed to have no role at all because we don't want the Fed to be in existence.) Krugman writes the following:

Many opponents of the House version of banking reform present their position as one of principle. House Republicans, offering their alternative proposal, claimed that they would end banking excesses by introducing “market discipline” — basically, by promising not to rescue banks in the future.

But that’s a fantasy. For one thing, governments always, when push comes to shove, end up rescuing key financial institutions in a crisis. And more broadly, relying on the magic of the market to keep banks safe has always been a path to disaster. Even Adam Smith knew that: he may have been the father of free-market economics, but he argued that bank regulation was as necessary as fire codes on urban buildings, and called for a ban on high-risk, high-interest lending, the 18th-century version of subprime. And the lesson has been confirmed again and again, from the Panic of 1873 to Iceland today.

The question is this: Why is this proposal a "fantasy"? I suspect Krugman would answer that in nearly every banking crisis, it always has been government to the rescue. For that matter, Murray Rothbard, who cut his teeth on banking crises by writing THE authoritative book of the Panic of 1819 (from his doctoral dissertation at Columbia University), pretty much has said the same thing.

Thus, Krugman would argue that when it comes to finance, we always must operate within a Second Best atmosphere, that the "best" form of regulation is not available because governments never fail to rescue the banks after they begin to fail systematically. OK, but that now brings us to the second problem: If we are agreed that government intervention is inevitable (and Austrians are not convinced that it is or has to be this way), then what is the best way to do it?

Krugman has argued for a return to what essentially was a banking and finance cartel that existed from the New Deal all the way until the early 1980s. He claims that Ronald Reagan was the culprit, bringing in "free-market ideology" in which banks somehow were totally deregulated and that banking regulators fell prey to the same myopic ideology that bewitched the politicians.

Here is the problem. We are looking at two different philosophies of regulation. The one that Krugman espouses is this: Regulators (who truly believe in the Greatness of Government) hover over the system, dispensing wise advice, stopping banks from making loans for idiot investments, and generally directing the system toward creating a wonderful economy.

This is what Progressivism always was about. Progressivists believed that "good government" would hire the "best and brightest" as regulators and decision-makers, and they would guide all of us with their expertise. The belief was (and, apparently, still is) that the experts knew all of the answers in how to successfully run an economy.

One does not even need to have read F.A. Hayek's "The Use of Knowledge in Society" to enlist one's b.s. detectors. Rothbard once noted that if these regulators were so brilliant and far-seeing -- indeed, much more far-seeing than most entrepreneurs -- then they obviously would have the requisite skills for taking part in the markets, making lots of money. Furthermore, under the kind of regulatory system that Krugman and others favor, people who have no vested interest in the success or failure of a set of investments nonetheless would be the ones making the decision of whether or not it should be allowed.

This should ring alarm bells on its face, for there is no way that such a system is sustainable. Ultimately, as we know, the system tends to be "captured" by the participants, and specifically the politically-connected producers. Furthermore, what ultimately happens is that the government essentially forms a cartel for producers. Whether in transportation, production of electrical power, or finance, government regulatory bodies have stifled innovation, forbade the entry of new firms into a regulated industry (at the behest of established firms), and held back economic growth.

For all of Krugman's reminiscing about the good old days of finance, it is easy to forget that the moves to "deregulate" the system did not come about because of ideology, as I outline in an academic paper I recently sent to a journal. Instead, the movement came because the system with its regulations on interest rates could not attract new money because inflation was outstripping interest gains, and people were putting funds into alternative investments, such as money market accounts, which not only were liquid but also were paying upwards of 8 percent or more. Banks simply could not compete.

Another problem was that banks were not prepared to deal with the new generation of technology and investments. For example, Ted Turner could not finance his proposed Cable News Network operation with conventional bank financing (banks were not interested in this far-flung idea that had, they believed, no chance of success). Instead he turned to Michael Milken of Drexel Burnham Lambert. Milken underwrote the operation by issuing low-rated, high-return bonds (what detractors called "junk bonds").

Because Milken was not part of the banking-finance cartel, ultimately his detractors were able to join forces with Rudy Giuliani and the New York Times (which is eternally fighting capitalism), and destroy Milken and his company. Perhaps the greatest financial mind of our generation was lost because of this.

I can say forthrightly that no great financial minds come out of the kind of regulated system that Krugman and others are demanding. However, I will concede this important point: throughout history, whenever the banks have fallen into trouble, the government has responded by trying to prop up these failing institutions, and the Federal Reserve System has been the mode of choice in the last three recessions. Furthermore, by promising not only help from the Fed but the expansion of deposit insurance has raised the moral hazard problems and made it inevitable that not only will the banks and financial houses take unnecessary risks, but that they are more likely to engage in what Austrians call malinvestment, that is, investing in unsustainable lines of production.

In my view, the only real financial reform would be to cut the banks and financial houses loose from central banking and from government deposit insurance. They would have to bear the costs of errors and would not be able to rob the taxpayers when the markets have declared their investments null and void. Unfortunately, even though this cold shower would not be politically acceptable, it is the only kind of reform that actually would work.

Krugman can quote Adam Smith all he wants, but somehow, I don't think that Ben Bernanke makes for a very good "invisible hand." We can argue about reform all we want, but in the end, the standard "reform" is not reform at all, but just the establishment of another financial cartel.