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?