Monday, May 14, 2012

Krugman, Bank Regulation, and a Bit of History

Everyone now knows about the infamous trading losses suffered recently by JP Morgan, but leave it to Paul Krugman to claim that a bank that operates within a heavily-regulated system somehow is "unregulated." Oh, I know, Krugman actually is claiming that even Dodd-Frank does not regulate enough and that we need to "turn back the clock" when it comes to banking and reinstall what we had in the 1970s.

Now, I agree with Krugman that banks should not be able to use depositors' money to engage in risky trades and the like, but the problem is not regulation or the lack of regulation per se. Krugman is correct; banks ARE different, but they are different because they legally can operate on the principle of fractional reserves.

As I teach my economics students, if someone deposits money into a bank and the bank lends out a large portion of that deposit, the original depositor still has an immediate claim to ALL of the money he or she has placed in the bank. (I am speaking of demand deposits here, not necessarily time deposits, some of which have penalties for early withdrawal.) When banks place themselves in precarious situations in which a large portion of their loan portfolios become shaky, they invite "bank runs" in which nervous depositors demand their entire share of deposits in the bank.

Obviously, a bank cannot survive a run if enough depositors make withdrawals and the bank cannot raise the requisite cash by calling loans or raising money some other way. However, the government has attempted to create ways to prevent runs. (Before the creation of the Federal Reserve System, banks would appeal for "bank holidays" in which they would close for a time being until the run died down, and banks also would make agreements among themselves, as they did during the Panic of 1907.)

The first in modern times was the creation of the Fed in 1913, with the central bank supposedly serving as the "lender of last resort." During a run, the Fed would loan money to member banks, and the presence of new money was expected to calm nervous depositors and ultimately end the run. Now, before the Civil War, depositors legally could ask for "specie" when making withdrawals. After the war, they got paper money for the most part, and today, that is all we are allowed to have.

While Krugman claims to be a liberal, nonetheless, he is an out-and-out reactionary when it comes to finance, and you have to remember that if Krugman were to have had his way, you would not be reading this, as computers as we know them along with the Internet as we know it and other forms of modern communications would not have existed because their start-ups would not have been financed by the banking system Krugman so admires. He writes:
So what can be done? In the 1930s, after the mother of all banking panics, we arrived at a workable solution, involving both guarantees and oversight. On one side, the scope for panic was limited via government-backed deposit insurance; on the other, banks were subject to regulations intended to keep them from abusing the privileged status they derived from deposit insurance, which is in effect a government guarantee of their debts. Most notably, banks with government-guaranteed deposits weren’t allowed to engage in the often risky speculation characteristic of investment banks like Lehman Brothers. 

This system gave us half a century of relative financial stability. Eventually, however, the lessons of history were forgotten. New forms of banking without government guarantees proliferated, while both conventional and newfangled banks were allowed to take on ever-greater risks. Sure enough, we eventually suffered the 21st-century version of a Gilded Age banking panic, with terrible consequences. 

It’s clear, then, that we need to restore the sorts of safeguards that gave us a couple of generations without major banking panics. 
 Ever hear of CNN and much of cable TV? The banking system that Krugman wants to bring back would not finance these things because they were new and untested and risky. Cell phones? Fuhgeddaboudit! McCaw Cellular was financed by Michael Milken and junk bonds, along with a whole host of other businesses based upon new technologies that really began to blossom in the 1980s.

What would the banking system have favored? Well, Apple certainly would not have been on the list. Instead, the bankers would have listened to the executives of IBM who bet the farm that the future was in mainframes. 

You see, the system that Krugman wants to re-impose, complete with a new version of Regulation Q, was very risk-averse, which meant it only stayed with the so-called safest areas of the economy. Now, maybe Krugman would be happy going back to the days of bell-bottoms and polyester clothing, but our economy would be much more primitive than it is now if Krugman were to get what he wants.

For that matter, Krugman has not been able to get his narratives correct. On numerous occasions, he has claimed that financial deregulation of the late 1970s and early 80s came about purely from "free-market ideology" and Ronald Reagan. Funny how history tells us different things.

The major deregulation act, DIDMCA, was passed in 1980. That year, Jimmy Carter (a Democrat) was president, the Democrats had an effective 59-41 majority in the Senate (58 Democrats and one independent who voted with the Democrats) and a whopping 277-158 majority in the House of Representatives. At the time of the act's passage, Carter had a large lead on Reagan in the polls and few people saw the results of November 1980 coming.

In 1982, with passage of the Garn-St. Germaine Act, all of the research I have done into it points to people other than Reagan as being the driving forces behind the changes in laws regulating Savings and Loans. The impetus to those changes did not come from ideology but from the hard fact that S&Ls were losing depositors and that many of their mortgages had low interest rates, but market rates at the time were well above 10 percent. Thus, it either was let them invest elsewhere or collapse altogether. That Krugman deliberately ignores that situation and rewrites history does not surprise me at all.

And, we are supposed to believe that the Greenspan-Bernanke "Put," with its promises of "liquidity," the actions of the Fed during the boom in pushing down interest rates, the political pressure on banks and other lenders to ignore the obvious and loan huge mortgages to people with questionable backgrounds, not to mention the actions of Freddie and Fannie, had NOTHING to do with the housing bubble and the meltdown. Instead, according to Krugman, it was the natural outcome of a pure free-market system that ALWAYS will create systematic errors because all entrepreneurs are like the band in "Animal House" that tried to march through the wall.

So, government creates a huge system of moral hazard, government encourages (and government "encouragement" always has coercion behind it) reckless lending, and we then conclude that all of this was ENTIRELY do to the "free market." Maybe in Wonderland, but not in the real world.

I would like to add one thing. Unregulated governments have floated huge amounts of paper around the world, much of it worthless, and the financial bubbles that government paper has created dwarf what we saw in the housing bubble. Yet, Krugman's answer is for governments to float more paper and resort to financial trickery to give this stuff "value."

One might have to assume that Krugman believes government agents, at least when it comes to finance, to be omniscient. Gee, if they are so smart, then why are they not leading Wall Street firms to new and glorious heights?


Jones said...

Are you assuming that big banks are the only means of financing for tech entrepreneurs? Surely you are cherry picking your examples...

Did Mark Zuckerberg need bank loans to grow Facebook? If I'm not mistaken he had plenty of VC's waiting in the wings.

Google and other innovative startups have even had seed funding from *gasp* the National Science Foundation.

Dennis said...

Commentators often point to Canada's banks as as example of a banking system that is properly "regulated" and therefore immune from bank runs and panics.

What they do not point out is that Canadian law has always permitted nationwide branch banking, so that risk can be spread out much more than it can in the U.S. which has a more balkanized banking system.

Despite this, however, it is important to note that Canada suffered just as much in the Great Depression despite having no bank failures. We also shared in stagflation and high unemployment through the 70's and 80's despite our supposedly "smarter" regulations.

When the latest financial crisis began in 2008, it has also been recently revealed that Canada's banks enjoyed a "stealth" bailout that was not admitted to by the government of the time.

William L. Anderson said...

Jones seems to forget that I am speaking of the 1970s and early 1980s, not the present time. And Facebook would not be financed under the regime that Krugman demands.

The regulated system that was in place 40 years ago was very, very risk averse, not surprisingly. So, people started finding ways to go outside the system, something that Krugman believes should not have been allowed.

CG said...

I'm really disappointed in this blog. I would love to see some robust discussion of Paul Krugman's posts, but this isn't it, sadly...

Your reading of him is in such bad faith, and your writing is just hyperbole and exaggeration.

No venture funding in the 60s and 70s? Come on...

But the worst is that none of your writing actually references data or even provides an inkling of a solution. Krugman has and does.

In the case of banking, what are you suggesting instead? Free for all? If your deposit is in a bad bank, too bad for you? Buy gold and put it in a safe in your house and pray nobody burns it down? Abolish fractional reserve banking? Where is John Galt?

I so wished there actually was some place on earth where they built the libertarian ideal, so you could go there and be happy. Actually, there are two places I can think of that come close: Somalia and Japan...

Mike M said...

CG, your citation of Somalia and Japan as the “Libertarian Ideal” reveals your complete ignorance of the Libertarian philosophy. Its fine to disagree with a particular philosophy, but you might want to try to understand it first.

CG said...

And that is, of course, the classic riposte - worthy of a politburo spokesperson. Additional bonus points for deflecting from the original ask: show me a place that actually practices libertarianism, or explain why such a place doesn't exist.

But there is meta-point here. It's all about somehow scoring points in some bizarre debating game. It's never about actually engaging in finding truth or understanding. Hence the bad faith readings and extrapolations, "gotcha" arguments and all that.

Mike M said...

CG there is no place that practices Libertarianism presently. There are lots of reasons why and a blog forum is not the place to spoon feed you the basics. There are plenty of resources that can provide you the education on the subject. Make an effort to seek them out.

I’m not interesting in a “debating game,” particularly with someone lacking the basic foundation of the subject matter. My point was pointing out the absurdity of your “examples.”

Dennis said...


Putting your money in an unsound bank is no different than investing it in an unsound business. That kind of thing happens all the time, and people routinely lose their investments. Nonetheless, enough businesses succeed to move the economy forward. Why should banks be under different rules?

Are you suggesting that taxpayers are obligated to save people from the consequences of their bad decisions? That kind of thinking is precisely what got us into the mess we are in today: if everyone is eligible for a bailout, then eventually everyone will need one. And the cost of such policies will mushroom until they consume the entire economy, leaving us all destitute.

CG said...

So many fallacies, so little time. Sorry, but I'll just pass. Claim victory, if you wish.

Mike M said...

CG, you’ve essentially just done what you criticized in your 10:46 pm. Brilliant.

Catholics for a Free Market said...

The ultimate response to Krugman remains Rothbard's history of money and banking. It should be a textbook, in school. Krugman glosses over history in order to justify central banking. Or he simply never learned history, in the first place.

Pulverized Concepts said...

Evidently, the philosopher-technocrats that run the Federal Reserve and Treasury department have it all figured out and would deliver prosperity to all if only the nincompoop US Congress would quit deregulating the banking and finance business. And do what Krugman recommends, as well.

Dan said...


You can't learn economic theory from Rachel Maddow then come here and weep crocodile tears for the lack of "robust debate" without appearing unseemly.

If you knew anything about Krugman other than what you hear from his other fans, it would be that there is a cottage industry of economists who routinely find discrepancies if not dishonesty in Krugman's "data." -- In fact, it's what he's becoming famous for.

Step outside the echo chamber sometime. You might learn something if you don't bruise your forehead first.

Anonymous said...

If you knew anything about Krugman other than what you hear from his other fans, it would be that there is a cottage industry of economists who routinely find discrepancies if not dishonesty in Krugman's "data." -- In fact, it's what he's becoming famous for.

Really I have been following both blogs and I have rarley found any sound econmic theories in this one.

Fearsome Pirate said...

CG, do you genuinely believe the government can, by the right set of rules and laws, create a world of zero risk to people who save and invest?

Do you have any evidence to this claim--any examples of a regime where banks never failed, and the rate of interest was always higher than the combined rates of inflation and taxation?