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.

Yes, Paul, I Agree! (Sort Of)

In today's post, Paul Krugman writes that we should not cry for the bankers, and I agree. Would that he had written that two years ago when Washington was airmailing billions of dollars to Wall Street to buy up the "toxic assets" (yes, an oxymoron) and "save" the system.

It always is frustrating in reading a Krugman column which begins with promise, as I don't want to be opposing the guy just to oppose him. Rather, I wish to oppose his arguments. For example, a few years ago, he was (appropriately) knocking down the so-called lump-of-labor fallacy that holds there are only a finite number of jobs in any economy, so they have to be spread out. (Union work rules arise from this theory, which is why we often see some ridiculous work arrangements in union contracts.)

As I was reading the column, I was agreeing wholeheartedly. Unfortunately, he ended with his usual non sequitur. He claimed that by not "fully funding" the Homeland Security Department(!), the Bush administration was falling to the "lump-of-labor" nonsense, leaving me with a "Huh?" response.

Likewise, today he begins by saying the following:

On Thursday, President Obama went to Manhattan, where he urged an audience drawn largely from Wall Street to back financial reform. “I believe,” he declared, “that these reforms are, in the end, not only in the best interest of our country, but in the best interest of the financial sector.”

Well, I wish he hadn’t said that — and not just because he really needs, as a political matter, to take a populist stance, to put some public distance between himself and the bankers. The fact is that Mr. Obama should be trying to do what’s right for the country — full stop. If doing so hurts the bankers, that’s O.K.

More than that, reform actually should hurt the bankers. A growing body of analysis suggests that an oversized financial industry is hurting the broader economy. Shrinking that oversized industry won’t make Wall Street happy, but what’s bad for Wall Street would be good for America.

At one level, he is correct. Wall Street DOES need reform, and it cannot be business as usual for the Usual Suspects. That being said, however, we need to remember that two years ago, the market was saying the following in no uncertain terms: "You bankers have had a wonderful run, with your bonuses and your big houses in Connecticut. It is time to say goodbye to all of that and live in the real world again."

However, being that Krugman believes the market always is bad, he called for bailouts and then demanded "reform." And, once again, we see that Krugman recognizes the disease, but then calls for a "cure" similar to bloodletting or pouring arsenic down the patient's throat.

There are two ways to travel here. The first way is what Krugman and others are demanding: Have essentially a state-run financial system in which the SEC controls ALL of the investment sectors, with the supposed "brilliant" regulators knowing exactly what investments to choose. Yes, I guess Krugman means people like this, which apparently populate that august regulatory agency known as the SEC:

As the country was sinking into its worst financial crisis in more than 70 years, Security and Exchange Commission employees and contractors cruised porn sites and viewed sexually explicit pictures using government computers, according to an agency report obtained by CNN.

"During the past five years, the SEC OIG (Office of Inspector General) substantiated that 33 SEC employees and or contractors violated Commission rules and policies, as well as the government-wide Standards of Ethical Conduct, by viewing pornographic, sexually explicit or sexually suggestive images using government computer resources and official time," said a summary of the investigation by the inspector general's office.

More than half of the workers made between $99,000 and $223,000. All the cases took place over the past five years.

My guess is that Krugman would claim that these people did not "believe in government."

There is another way, and that is to make these firms accountable to the market for their actions. Yes, there is moral hazard created in the markets and, yes, people scratch each others' backs, but that also goes on in government, and I would defy Krugman to create a government agency that ultimately does not become yet another example of how "Capture Theory" works.

As Peter Schiff noted in this speech (yes, I repeat stuff from an earlier post), the market would have caught onto Bernie Madoff long before the SEC had figured out the scam, but because the SEC was putting its bill of approval on Madoff's secret Ponzi operation, he went undetected until the whole thing fell down.

Are we going to have that kind of Wall Street, a financial system in which individuals actually are accountable to their errors? Not at all. The irony, however, is that Krugman believes that by creating a Bigger Financial Cartel, he is going to get the moral hazard out of the system. Right.

Of course, Krugman also believes that the Federal Reserve System has "saved" our economy when, in fact, it is making it even more unstable and vulnerable to future meltdowns. Unfortunately, a nanny-state liberal like Krugman simply cannot bring himself to believe that government run by People Who Think Like Him actually can run an economy -- instead of running it into the ground.

Yes, It's a Republican Plot

Most of the economists I have known have been associated loosely with the Republican Party or maybe the Libertarians. (Mark Thornton and John Sophocleus, two of my favorite economists and writers, both ran for statewide offices in Alabama as Libertarians, and both did better than most other Libertarian candidates have done. Neither are kind to the Republican Party.)

That being said, I never have dealt with any economists that were hyper-partisan Republicans, and at most economic events dominated by my friends, I heard more criticism of Republicans than I heard praise. Then there is Paul Krugman.

Even though the Republicans are nearly endangered species in this Congress, Krugman still insists that they are like Goldstein, falsely convincing us that we are at war with Eurasia when, in reality, we are at war with East Asia. For example, as I have pointed out many times before, he continues to claim that it was Reagan and the Republicans that gave us financial deregulation when the most important deregulation bill, DIDMCA, was passed in 1980 when Jimmy Carter was president and Democrats had the same majority in the Senate and an even bigger one in the House.

So, I hardly am surprised when Krugman insists that Goldstein, er, the Republicans, might kill the present "financial reform" bill. Now, if this is anything like the "reform" that gave us Sarbanes-Oxley or the Patriot Act that "reformed" how the government conspires against its citizens, then I am not sure I am in the market for such an act and would cheer on anyone willing to filibuster it.

Krugman writes:

I have a theory about the problem here. My understanding is that Obama officials have looked at the polls, which show that the public overwhelmingly favors cracking down on Wall Street; so they assumed that the GOP wouldn’t dare stand in the way. But they seem not to have learned, even now, that the right has an awesome ability to create its own reality: that Mitch McConnell et al would stand in the way of reform while claiming to be taking a stand against Wall Street.

that is a most interesting theory, actually. Now, what does he mean by "cracking down" on Wall Street? What he means is that Wall Street becomes the repository for buying government bonds (after the Chinese decide they don't want any more of that junk).

Furthermore, what he wants is to create what essentially would be a large financial cartel held together by the wise regulators from the SEC (who, on application, would have to pledge that they, like Krugman, "believe in government"). I doubt Krugman will use the "C"-word, but that is what he wants, and he forgets that the last SEC-run financial cartel fell apart about 1980, whether or not he wants to believe it. Furthermore, if he believes that giving the Federal Reserve System even more power than it has now is "reform," well, Lucy van Pelt has a football she wants you to kick.

Of course, he could not resist hinting that not falling into line with his view of "reform" is racist. In his own words:

And let’s be clear: there’s a sort of tribal thing going on (and I don’t necessarily mean race, although that’s part of it). The hard right has managed to convince a large number of Americans that it consists of people like them, whereas progressives are alien and untrustworthy; in the face of that, rational arguments don’t make much of a dent.

That the "Progressives" are our friends reminds me of the scene in "The Unbearable Lightness of Being" in which dissidents are being interrogated after the Soviet crushing of the Prague Spring, with the interrogator shouting, "Don't you know that we love you?!?

Krugman Attacks the Austrians

In a blog posting today, Paul Krugman once again attacks Austrian Economics, using what I see as a series of non sequiturs, not to mention contradicting his own Keynesian beliefs. He declares:

My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.

But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?

Krugman has wrongly attacked Austrian Economics before, using this same argument and then calling the Austrian Theory of the Business Cycle a "hangover theory." However, as Robert Murphy has explained, the ATBC is not a theory that claims that good times automatically must lead to bad times; instead, it is a theory that concentrates upon malinvestments that occur during and boom and must be liquidated.

Unfortunately, Krugman's claim that Austrians cannot explain why there should not be high unemployment during a boom (because assets are being pulled in a direction away from what consumers would prefer through their purchases) actually contradicts his own Keynesianism. Remember, under Keynesian theory, all factors, including labor, pretty much are homogeneous, so labor automatically would transfer into the booming sectors, and Krugman's so-called refutation is built upon an assumption that labor is fixed and cannot move elsewhere. This makes no sense at all, but, then Keynesianism is a crude theory that does not stand up to scrutiny.

Krugman goes on with yet another straw man argument:

I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps.

Actually, Austrians have given clear answers, but Krugman does not want to hear them, resorting to insults instead. The article I listed earlier by Robert Murphy goes into rich detail in answering each of Krugman's points. Here he deals with Krugman and capital theory:

You can't understand Austrian business-cycle theory (ABCT) unless you first understand the Austrian view of the capital structure of the economy. In this article,I showed how Krugman was simply incapable of grasping ABCT because he lacks a rich enough model of capital. For those newcomers who are unfamiliar with ABCT, I strongly encourage you to read the fuller discussion in the hyperlinked article.

Here is another Murphy quote regarding why there would not be unemployment in other sectors:

On the other hand, other sectors don't need to contract, because (unlike the scenario of genuine savings) nobody is cutting back on consumption. This is precisely why the Fed-induced boom is unsustainable — real resources have not been released from consumer sectors in order to fuel the expansion of the capital sectors. Because modern economies are so complex, the charade can continue for a few years, with entrepreneurs cutting corners and "consuming capital" (i.e., postponing necessary replacement and maintenance on equipment) while both investment and consumer goods keep flowing out of the pipeline at increased rates. But the music eventually stops, since (after all) the Fed's printing of green pieces of paper doesn't really make a country wealthier. When the Fed "cuts interest rates" it isn't really creating more capital for businesses to borrow; it is instead distorting the signal that the market interest rate was trying to convey.

What Krugman fails to understand about booms is that they are not sustainable. The occur precisely because of malinvestments caused by government monetary (and sometimes fiscal) policies. Furthermore, government compounds the problem by trying to prop up the failed sectors, throwing good resources into a financial black hole, instead of permitting the failed sectors to be liquidated or transferred to other uses and to let the proper proportions of the economic fundamentals to get back into balance.

However, with Keynesians, because all factors of production are homogeneous, there is no need to get factors into balance, since they always are in balance, anyway. Thus, in the Keynesian view, we just need stimulus forever.

Now, there is one problem that Krugman has created for himself, and it is this: If factors of production behave the way he says they do, and if booms always can be sustained through government spending, then why are there financial bubbles? If there are no proportions that get out of balance, why could not the housing boom have gone on indefinitely? Krugman's theories simply cannot answer that question, except to say that capitalism is bad and needs to be regulated by government.

Folly and "Financial Reform", Part I

In my review in the Freeman of Paul Krugman's The Return of Depression Economics and the Crisis of 2008 (a book that I am requiring for my MBA students this spring) I noted that he made some insightful observations and comments. However, I continued, he then draws all of the wrong conclusions:

...alas, in the end Krugman resorts to the arguments of the great economic cranks of history, from Silvio Gesell to John Maynard Keynes. He’s like the mechanic who expertly describes a problem with your fuel pump—then insists your car needs more gas. If the tank is full, he tells you to attach an auxiliary tank.

In other words, Krugman is still the one-trick pony featured in the Times. Whatever the problem, his solution is always the same: inflation.

Thus it is today with his column on financial reform.Krugman correctly notes that the financial sector took risks that clearly were out-of-bounds, yet they also understood that the government had their backs. All of us can agree on that point, but the next question is where we part: Now that the financial meltdown has happened, what should we do about it?

Austrian economists like me believe that we need to move entirely away from a financial sector backed up by the printing presses of the U.S. Government and the monetary manipulations of the Federal Reserve System. Such a system always is doomed to failure because the symbiotic relationship between the financial sector and government is inevitable when government agents can descend on that sector and overnight change outcomes.

(The predations of Elliot Spitzer and Rudy Giuliani come to mind. While both men were effusively praised by Krugman's NYT employer, Wall Street got the message and gave both men massive amounts of campaign contributions. Like Willie Sutton, politicians know they can raid Wall Street because "that's where the money is.")

Krugman, on the other hand, approaches financial regulation from this point: Democrats always good, Republicans always bad. Democrats want wise regulation, Republicans want wild speculation. Now, that is something I expect to hear from political hacks or from Keith Olbermann, not to mention the editorial writers and columnists at the NYT.

I don't expect a decorated economist like Krugman to give in to this simplistic hackdom, and that is what he is doing, like it or not. Furthermore, he gives a skewed history of the rise of what he and others call the "shadow banking system."

In Krugman's history, the tightly-regulated banking system was almost impervious to failure because regulators kept it from going after Big Risks. Unfortunately, those bad free-market ideologues both created a shadow system and then bamboozled the Wise Government to deregulate the banking system, ultimately leading to the present crisis. That is a history that plays well to both his audience and the current crop of politicians in power.

As I said before, I expect to hear such nonsense from the Usual Suspects, just as I expect Ann Coulter to claim that Barack Obama is not pursuing Big, Bad Muslims around the globe with enough ferocity (and, thus, adding further to our government's financial bankruptcy). However, as economists have noted for decades, the real story of regulation is much more nuanced and requires for people not to give into partisan diatribes.

What Krugman does not tell us is that by 1980, the small, wonderful banking system was in crisis in no small part because of the regulation Krugman praises. Regulators operate according to a set of incentives in which they receive no credit for "picking winners" but are in hot water if they allow actions that result in failure. Therefore, the default for regulators always will be "no."

Ever hear of MCI? Of Borders Bookstore? Of McCaw (now AT&T) Cellular? Of CNN? Of fiber-optics and a thousand other high-technology initiatives? The reason you have heard of them has been that "shadow banking system" that Krugman condemns. The heavily-regulated banking system would not touch them because these were new ventures that were outside of the usual kinds of things (like government bonds) that banks were permitted to help finance.

Like the entrepreneurs in Elizabethan England who set up shop outside London (because the Queen had granted monopolies in that city to her favored people), something noted by economists Robert Ekelund and Robert Tollison in their book Politicized Economies, the shadow financial system grew precisely because it allowed investors to pursue profitable opportunities that the regulated banking system could not.

Furthermore, the "tightly-regulated" banking system, which really was more of a regulated cartel, was losing capital. Part of the regulatory deal was that government would limit the risk the system could take, but it also would place ceilings on interest rates the banks could offer. At a time when inflation was in double-digits, but banks only could pay depositors something in the range of 6 percent, people flocked to money market accounts being offered by financial entrepreneurs that were relatively safe but also paid higher interest rates.

Like the entrepreneurs who broke down the Mercantilist regulatory system of post-Renaissance England simply by locating elsewhere, the financial entrepreneurs like Michael Milken helped to finance what would be our economic future for two decades. Of course, the established financial firms on Wall Street that were being left out of the action did not like upstarts like Milken, and so Rudy Giuliani did their dirty work, urged on by the NY Times and others.

(By the way, Milken was a liberal Democrat and hardly falls into the category of the "free-market, Republican ideologue" so demonized by Krugman and others. In other words, Milken did not fit the stock profile, but nonetheless was pushed into that false category anyway.)

The background being set, in Part II, I will look at Krugman's current statements and point out why they are wildly untrue and misleading.

What About Financial "Reform"?

Once again, we see Paul Krugman promoting the fantasy that our financial system in 1980 was a "robust," productive system done in by the ideology of "deregulation." Well, not exactly.

People who were around then might remember that Krugman's employer, the New York Times, praised the first major deregulation bill, the Depository Institutions Deregulation and Monetary Control Act of 1980. Yeah, you know how those NY Times editorial writers are a bunch of conservative, free-market Republicans.

This time, Krugman claims that as long as regulators are "smart" and "well-intentioned," then they can pull off the whole deal. I think it takes more than that. Krugman, unfortunately, demonstrates his ignorance of finance and of economics (not to mention economic history) in the following missive:

The pre-1980 system was, I’d argue, pretty robust. Bank regulators didn’t have to be all that smart, because the rules were simple — and besides, the large franchise value of banks, the fact that they faced limited competition and were almost guaranteed to be profitable, made bank executives unwilling to take big risks of killing the goose that laid golden eggs.

However, the "golden eggs" of the 1980s were industries in which these bank executives refused to make investments. Ever hear of CNN? What about MCI? McCaw Cellular (now AT&T Cellular) might jog the memory a bit.

These and more all were industries that the banking system -- that "robust" system Krugman praises -- ignored. Krugman really wants us to believe that the high-technology industries, the very industries that are vital to our economic well-being, really just came into being, despite the fact that the banks (regulated by "smart and well-intentioned people") would not make loans to them. Indeed, every one of these firms came about because of the alternative system (specifically, Michael Milken and his "junk" bonds that turned out to be good investments) that Krugman wants to make illegal.

Now, I will be the first to say that if the government is going to backstop the financial system, providing bailouts and other goodies to prop up failure, then the system needs to be regulated. However, keep in mind that this kind of a system is not going to be effective in financing those sectors of the economy we need to lead us out of this recession.

However, none of that matters to Krugman. Here is a guy who really believes that all we need is for a government to have the "courage" to print money, borrow, and spend recklessly.