Krugman Fails to Answer the Pertinent Question: Who Made This Meltdown Possible?

With the SEC's recent filing against Goldman-Sachs, it looks as though the government is doing its best to deflect attention from its own role in the financial meltdown while blaming it on everyone who attended the drunken party, while failing to include the Federal Reserve System, which was the main supplier of the financial alcohol.

As I have said before, there is plenty of blame to go around. Wall Street executives were not exactly refusing to put the Fed's alcohol in the punchbowl and did everything possible to encourage the whole country to partake. Unfortunately, unless we get to the most important lesson -- that the Fed played the most important single role in creating the meltdown -- then we really are going to living in a repeat of "Groundhog Day."

In his column today, Paul Krugman repeats the tired canard that it was a lack of regulation that created the conditions for the meltdown. The capitalists were greedy, and the Bush administration -- lovers of free markets all -- simply stood by while the system went to hell. Furthermore, as the SEC alleges, it seems that some firms actually were shorting mortgage securities while, at the same time, promoting them. (Investors call it a "straddle," and it is common practice for people who trade in options.)

Krugman asks:

So what role did fraud play in the financial crisis? Neither predatory lending nor the selling of mortgages on false pretenses caused the crisis. But they surely made it worse, both by helping to inflate the housing bubble and by creating a pool of assets guaranteed to turn into toxic waste once the bubble burst.

As readers know, I tend to be much more skeptical about allegations of fraud, simply because I have seen federal prosecutors use the term too many times and clearly in situations in which no one intended to engage in what traditionally is known as deception. I'm not going to say that real-live criminal fraud does not exist on Wall Street or that there were fraudsters in the mix before the meltdown.

However, it is easy to dismiss everyone as a crook instead of understanding that the biggest engine of fraud on Wall Street was not Goldman-Sachs, as bad as the firm might be. No, it was the Fed.

Krugman and I both agree that the housing boom and all that it entailed was not sustainable. (Although, there is nothing in the Keynesian theory that says a boom, even a housing boom, cannot go on forever, just as long as government provides the money.) We even agree that the Fed was holding down interest rates.

The disagreement comes at this point, and it is huge. Krugman has defended the Fed's policy of having artificially-low interest rates, claiming that regulation can steer the money in the right direction. He writes:

But did I call for low interest rates? Yes. In my view, that’s not what the Fed did wrong. We needed better regulation to curb the bubble — not a policy that sacrificed output and employment in order to limit irrational exuberance.

In other words, after the Fed brings the liquor to the party, it then will effectively regulate its consumption. However, cheap money carves its own trails.

There is another point. Krugman goes off on a number of derivatives and swaps, but he forgets that the underlying reason Wall Street could do this was because the Fed was showering The Street with easy money. You cannot have an easy money regime AND sound investments. It just won't happen.