Regulatory Romanticism

Although I find myself in disagreement with most of what Paul Krugman writes, he has some blog posts this week that definitely lend to larger discussion. The one I want to cover today is his one on "Financial Romanticism," although I do want to get to his post on the Austrian view of 100 percent reserve banking. (My guess is that Bob Murphy and maybe some others in the Austrian camp will jump on it before I do, and that is fine with me.)

Krugman is first and foremost a Progressive, and Progressives believe that a society makes "progress" by advancing the powers of the State. Unlike, say, Thomas Jefferson, who believed that the State gained power only by taking away liberties of individuals, Progressives want us to believe that freedom actually is enhanced when the State imposes its Wise Will upon individuals who may not know better.

In this post, Krugman openly mocks individual freedom with this title (and, of course, the South) and hints that only expansion of the State can make our lives better. And in this post, he lets us know that the government passenger rail service makes HIM feel more free, so it must be good. (That much of this particular "freedom" is financed by people who will not have the opportunity to ride on those trains, and who have less personal freedom of their own because government is confiscating their income to fund Krugman's rides, seems to be lost on Krugman. What matters is what HE wants, not what the Great Unwashed might think.)

His "Financial Romanticism" post does go into areas of thought that interest me, as I wonder if the Real World ever would permit a banking sector that is not bailed out at times. Before I give my own thoughts, however, let me deal with Krugman's point that because the fractional reserve system of modern banking can lead to a "cascading crisis," some sort of bank regulation is inevitable. He writes:

...even if you persuade yourself that the moral hazard created by financial firefighting outweighs the benefits of avoiding a 1931-style cascading crisis, the fact is that policy makers will intervene. Hank Paulson set out to make Lehman an example; two days later he was staring into the abyss.

So the only feasible strategy is guarantees and a financial safety net plus regulation to limit the abuse of those guarantees. It’s imperfect; it faces the constant threat of regulatory capture; but it has worked in the past, and it’s the only game in town. (Emphasis mine)

Thus, one tries to put the regulatory fences at a place where the banks don't get too big and the failure of one institution leads to a run on other banks. I understand the logic and realize that there is strength in his argument of inevitability, and appreciate his point that we are dealing in a second-best world.

There is something that Krugman leaves out, however, as his own Progressive thinking tends to lead him to the belief that the regulatory system that comes from the executive branch always will give the "best" results. The "rule by experts" has been a dream of Progressives for more than a century, and no public intellectual has absorbed this religious belief more than Paul Krugman.

As Krugman sees it, any regime that holds financial institutions completely responsible for their own entrepreneurial errors is bound to bow to the inevitable. If left on their own, banks become too big, and ultimately will be come too risk-loving, especially when they are not being reined in by risk-averse bureaucrats. And while he gives a nod to "regulatory capture" theory, nonetheless he seems to believe that the gods of expertise (and rule by the "correct" political party) ultimately will overcome such problems.

Krugman, however, leaves out something that I believe that the Austrians also forget (and I will critique both sides): politicians, like the famous bank robber Willie Sutton, also know "where the money is." Furthermore, unlike Sutton, who allegedly did not carry loaded guns into the banks that he robbed, the politicians tend to be much more predatory and threaten much more violence when they are seeking political "contributions" from banks and other businesses.

The regulatory theory to which Krugman refers is "Capture Theory," in which the entities that are regulated "capture" the process. The typical Progressive antidote to that theory is for regulators to be liberal Democrats who are so pure of heart and so wise and caring for consumers and True Believers in their Holy Mission that they are able to overcome the temptations. (Yeah, Krugman really does believe that, and for those who would argue, read his columns in the aftermath of Katrina. He claimed here and here that the problem was that the Bushies simply did not believe in the power and goodness of government.)

Fred McChesney, however, has developed a different kind of "capture" theory, one in which politicians play an active role in the predatory activities and act like a mafia. He writes:

But a politician has an alternative for raising money: selling protection. He can agree not to do something that otherwise he says he would do, something that would reduce the wealth of the potential donor. The most obvious burden that can be threatened is a tax, but there are any number of others that a politician can propose and then withdraw for a price. A private citizen will be just as willing to pay for a special favor worth $1 million as he will to avoid a $1 million tax. (This assumes constant marginal utility of wealth; with declining marginal utility of wealth, a citizen will pay more to avoid the $1 million loss than for the $1 million gain.)

This, then, is the essence of the political protection racket. Superficially, selling special favors and selling protection do look the same: payment is made to the politician in both cases. But in the extortion racket, citizens are made to pay, not for special favors from Uncle Sugar, but to protect private wealth that they have earned the old-fashioned way, outside the political process.

He continues:

One observes this sort of protection being sold routinely, at all levels of government. Legislative extortion is commonly practiced through so-called “milker bills,” to use a term popular in California. A bill is drafted and submitted, not because there is any legitimate need for it, but because it threatens some private person or group that predictably will pay to have the bill withdrawn. “Juice bills” is another term for those legislative proposals intended to squeeze private interests for cash.

Now, I am sure that Krugman would note that McChesney is referring to the legislative branch of government, not the executive branch, where the Pure of Heart Regulators reside. His view is built upon the assumption that legislators are human, but regulators who prescribe to Progressive Theology are able to overcome any weaknesses of knowledge and any temptations to "sell out" to private industry.

That tends not to be the case, as the "revolving door" between the regulators and the regulated demonstrates. For example, after leading the Clinton administration's anti-trust case against Microsoft (which had been guilty of the "sin" of not making "donations" to politicians and paying proper homage to D.C.), Joel Klein went to work for an international firm to help them avoid anti-trust pitfalls, making millions of dollars in the process. (Much of the government's Microsoft work was done by private law firms that also made millions of dollars in the process, but no doubt everyone was working out of the goodness of their hearts.)

Krugman also fails to address the desire that individuals have for power, and when power and ego combine within the regulatory confines, one can find the prescription for outright dishonesty and tyranny. I remember when I wrote an article 20 years ago for Reason Magazine on acid rain that the way that the Environmental Protection Agency destroyed the career of a good scientist that the regulators in EPA engaged in one big power trip that had nothing to do with the science or the effects of so-called acid rain.

For that matter, anyone who goes through an airport security line or has dealt with any "law enforcement" agent employed by the feds knows that employees of the executive branch hardly are "dedicated public servants" who are pure of heart. People who have power without accountability are going to be tempted to operate at the lowest common denominator, and it does not matter if they are Republicans or Democrats.

On one last matter, Krugman seems to indicate that Henry Paulson was operating out of "free-market ideology" when he failed to intervene in the collapse of Lehman Brothers. Given that Paulson and his former firm, Goldman-Sachs, were major Wall Street players, I doubt seriously that Paulson saw his role as Secretary of the Treasury as being to promote free enterprise in finance.

I do conclude that I agree with Krugman in part: actually enforcing a regime of true free-market finance is difficult if not impossible. For example, in the 1840s, when there was no central bank to act as the "bail-out" entity, many U.S. states required banks to purchase the states' canal bonds in return for receiving and keeping state charters. When the states defaulted (they had not anticipated the growth of railroads), there were numerous runs on banks.

In other words, even if everyone wanted a free-market system in finance, politicians being what they are would be predatory, and bankers, in turn, would spread around money to influence politicians. There really is "nothing new under the sun," and I admit I don't have the answers here. But, neither does Krugman.