On the surface, all of us can agree. The financial meltdown on Wall Street came about because huge numbers of "investments," hedge funds, and other financial devices were pyramided atop securitized mortgages, which were being sold as though they were gold, instead of the fools gold they really were. To many people, it was obvious that this whole scheme was unsustainable, and when it went down, it went down quickly and very hard.
(In 2006, when I was appealing a tax ruling on my house, I told an Allegany County tax board that the housing market was, in fact, a bubble that would burst violently. They laughed at me, and one person said, "We don't see that happening." I replied that it would -- and it did.)
It is not hard to see in hindsight what happened. However, Krugman and I disagree on a large number of particulars, and one of them is the role of regulation in this mess, and the other is, well, the role of regulation needed to fix it.
Now, I agree with most (but not all) of what he writes here:
It’s easy to see where concerns about banks that are “too big to fail” come from. In the face of financial crisis, the U.S. government provided cash and guarantees to financial institutions whose failure, it feared, might bring down the whole system. And the rescue operation was mainly focused on a handful of big players: A.I.G., Citigroup, Bank of America, and so on.He is correct about the moral hazard in the system, but the bailout was not necessary; in fact, it has blocked the needed liquidation of bad assets in the system and it is preventing a recovery from happening. Here we see the huge gulf between the Keynesians (and Friedmanites, for that matter) and the Austrians.
This rescue was necessary, but it put taxpayers on the hook for potentially large losses. And it also established a dangerous precedent: big financial institutions, we now know, will be bailed out in times of crisis. And this, it’s argued, will encourage even riskier behavior in the future, since executives at big banks will know that it’s heads they win, tails taxpayers lose. (Emphasis mine)
To a Keynesian, all assets pretty much are homogeneous, and what really matters is spending. Consumption is little more than people "buying back the products they make" in order to keep the Circular Flow intact. Thus, throwing more money into the economy via borrowing and printing will keep the economy from falling into the pit of deflation and helping set the stage for a recovery. To a Keynesian, the worst thing that can happen in deflation, for it creates an endless downward spiral that ends at an "equilibrium" of high unemployment and hopelessness.
(Robert Murphy in his Politically Incorrect Guide to the Great Depression has a good commentary on this error. He points out that if this were true, then the Federal Reserve System's tightening of money in 1921 would have thrown the economy into a pit from which it would not have emerged. Instead, the economy soon afterward had a robust recovery.)
Austrians take a different tact. First, consumption is a purposeful activity, done by people to meet their needs and desires. Second, the basis of consumption is production; we consume because we produce, and we pay for consumption by exchanging what we have produced for those goods and services we need.
This implies that there is a balance within the economy that must be sustained. The housing meltdown came about because the go-go housing market could not continue, as the pouring of resources into housing pulled the entire system out of balance. Unfortunately, too many economists have claimed that the housing meltdown came about because housing prices fell (Martin Feldstein comes to mind here); no, prices fell because this market could not be sustained no matter how much money the government and the banks threw into it.
In other words, the Keynesians and Friedmanites have made the fundamental error of violating what Carl Menger called the Law of Cause and Effect. They have assumed that the effect really was the cause of the calamity. Furthermore, they continue to demand "solutions" that only prop up the malinvestments -- at the expense of the rest of the economy, the still-healthy portion that will not be healthy much longer if the government continues its path of borrowing, printing money, and propping up the bad investments.
I do agree with Krugman that the moral hazard problem is real, but I disagree with his proposed "solutions" that really only compound the problem. What he proposes is to bring back the banking regulations that existed from the New Deal to the early 1980s, and then putting the rest of the financial system under the same regulatory umbrella. In his view, cited elsewhere, "smart" and "well-meaning" regulators can take over from there and keep calamities from happening.
Before going further, I agree with Krugman that moral hazard was a huge problem and I also agree that under the current mentality that grips the system today, the bankers and financial barons invariably will be successful in asking for new money to clean up the mess they have made. However, Krugman also forgets that the establishment of the Fed in and of itself was a huge moral hazard. The original purpose of the central bank was to be a backstop that would provide newly-printed money to member banks in case of a run or a "panic," which occurred once in a while. The presence of the Fed sent a signal to the bankers that the government had their backs, and that problem continues to this day.
There is another issue I have noted before, and that is the difference between Krugman's view of where regulated banking stood in 1980 and the view of Austrians and others. According to Krugman, the banking cartel (which it really was) was doing just fine, but ideological Reaganites came in and undid the whole carefully and wisely-planned structure, all in the name of ideology. Then they created an entire shadow system, also done from ideology.
In a word, that view is nonsense. The banking cartel was losing capital because the government held down interest rates it could offer depositors even while inflation raged in double-digits. People sought other venues and found them. In the meantime, Michael Milken already was helping to finance ventures that the banks would not touch. (As Daniel Fischel notes in Payback, much of the recovery of the 1980s came from Milken's financing methods.)
As economists such as George Stigler and Sam Peltzman pointed out, regulation has the effect of offering protection to regulated firms, but also serving to keep out competitors. In other words, contra Krugman, regulation creates what in effect are government-sponsored cartels. From this, we see "Capture Theory" emerging, as the regulated industries and their government regulators form a tag team that operates to the benefit of the people in the system -- and against consumers.
The ultimate irony is that Krugman and others are demanding re-regulation as a form of "consumer protection," which clearly has not been the pattern of regulation. Krugman can deny this point, but he is the one who is wrong.
Krugman can provide this fantasy of regulation all he wants, and I am sure that plenty of people will believe it, but that does not change the fact that "Capture Theory" is real and provides a much stronger view of regulation than does Krugman's Keynesianism. The re-regulation he espouses not only will make the economy weaker (as it protects the current set of malinvestments), but it also sets the stage for crises in the future.
Instead, we need to abolish the government backstops altogether and stop this bailout foolishness, which only provides the economic agony we are experiencing. The problem is not "too big to fail" or "we need more regulation." No, what we need is to clear the moral hazard out of the system and let the economic assets move to their real values.
Only then will we have a real recovery.
1 comment:
Bill,
Great post, as always. Just one thing: I believe in paragraph 9, instead of "To a Keynesian, the worst thing that can happen in deflation," it should say: "To a Keynesian, the worst thing that can happen IS deflation,"
Thanks
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