Folly and "Financial Reform," Part II

In Paul Krugman's column on "financial reform," he makes it sound so simple. Just put, smart, "well-meaning" regulators in power, and they will make sure that the financial system will work just fine.

Unfortunately, while Krugman understands the technical jargon about finance, he really does not comprehend the economics behind it. According to Krugman, government regulators can pick "winners" just as well as anyone else can do, and since capital itself, economically speaking, is homogeneous, well it is pretty easy to run an economy. Just let the regulators decide where the loans shall go, and there won't be any risk, and the economy will work like a clock.

This is fantasy. If government regulators really could pick winners, as Krugman seems to think, then people that wise immediately would be hired by investment firms -- at many times their government salaries -- and lead Wall Street firms into investment bliss. In truth, reality is much more complicated.

If the world Krugman still champions were in existence now, I would not be writing this piece, as laptops -- if they existed at all -- would be much more primitive than they are now. Forget about the Internet, since copper wire still would be transporting telephone calls, and the Internet as we know it could not exist under such technology.

Television would continue to be the dreadful fare of a few network stations, Dan Rather still would be on the air (since there would have been no bloggers to expose his dishonest use of forged documents in a diatribe against President George W. Bush), and the only way to be able to read Krugman would be if one purchased a paper edition of the New York Times. That is because the "shadow" system Krugman so despises, was the system that financed most of the high-technology ventures that have become an integral part of our lives.

Someone like Krugman cannot understand this because in his world, economic outcomes depend only upon how much money the government is willing to print. Whether or not the financial system operated under 1930s rules or if investors were free to pursue the new technologies would lead to exactly the same outcomes, at least where what was available to consumers is concerned.

In other words, Krugman has no concept of the Law of Cause and Effect. To him, the effect always is the same, economically speaking. However, to Austrian economists, the Law of Cause and Effect is front-and-center in understanding economic outcomes.

Austrians understand that the banking system Krugman so praises could not and would not have financed what turned out to be a massive economic recovery during the 1980s. That role was left to the "shadow" system.

Now, most of the deregulation initiatives of the 1980s and 1990s really was re-regulation, and the system became increasingly skewed, as politicians sought to maximize political contributions coming from the financial sector. Unwise laws like Sarbanes-Oxley limited possibilities of profit within our borders, so banks and brokerage houses turned to other means to make money.

While it is easy to decry a lack of oversight when the financial system went ga-ga over what turned out to be toxic mortgage securities, in hindsight, we realize that had the politicians not deliberately shackled the productive U.S. economy, perhaps banks and brokerage houses might have pursued more sound "investments" than pyramiding funds atop mortgage securities that turned out to be worthless.

Furthermore, Krugman forgets that the loose credit policies of the Federal Reserve System helped to trigger reckless lending and touched off an unsustainable boom. (Krugman does not believe booms are unsustainable. He just believes that if a boom slows down, government needs to print lots of money to keep the party going.)

Now, I agree with Krugman that the banks and brokerage houses were irresponsible, but one does not forget that people who believe that the government "has their backs" are going to be more reckless than people who understand that if they fail, they have to pick up their own pieces. Krugman never seems to fathom that the moral hazard created by the government backstops ultimately set the stage for this disaster. Nor is he ever going to change his tune; it's his story and he is sticking with it. I'll stick by my account.

Krugman, Japan and the Keynesian Cult

One of my pet peeves with Paul Krugman's writings has been his constant rewriting of history, a rewriting that just happens to coincide with left-wing political talking points. For example, we hear that the Great Depression occurred because Herbert Hoover was a staunch believer in laissez-faire and took the advice of Treasury Secretary Andrew Mellon, who called for liquidation of bad assets to "purge" the economy of whatever was "rotten" in the system.

However, even a cursory reading of the history demonstrates Hoover openly rejected Mellon's advice and tried stimulus after stimulus, only to see the economy crumble. (Krugman's response always is the same: Hoover tried "too little, too late." So, whenever ANY so-called stimulus does not work, the standard Krugman-Keynesian response is that the "stimulus" was "too small.")

Thus, he takes issue with a paper by Alberto F. Alesina and Silvia Ardagna in which the authors claim that tax cuts, as opposed to increases in government spending, provide a better "stimulus" for a moribund economy. Not having read the paper, I cannot make any "expert" or otherwise comments except to say that the issue at hand ultimately is not "stimulus" at all; it is the presence of malinvestments that must be liquidated in order for the economy to recover.

Once a boom has collapsed, the boom-era malinvestments begin to act like cancer cells, sucking the life out of what is left of the economy. It is better to let the market salvage any malinvested assets that it can while permitting the others to liquidate rather than to have these sick "assets" bring down the entire economy. (Government Motors and Chrysler, anyone?)

Krugman, however, goes on to criticize the paper on two points: (1) the presence of a "liquidity trap" in which monetary expansion by the central bank no longer can "stimulate" anything, and (2) the record of so-called expansionary policy of the Japanese government during Japan's decade-long recession of the 1990s. Let me begin with the "liquidity trap" arguments.

Murray Rothbard in his classic America's Great Depression devastates the Keynesian "liquidity trap" in the following passage:

...the Keynesians are here misled by their superficial treatment of the interest rate as simply the price of loan contracts. The crucial interest rate, as we have indicated, is the natural rate—the "profit spread" on the market. Since loans are simply a form of investment, the rate on loans is but a pale reflection of the natural rate. What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers' goods prices falling faster than do consumer goods' prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned "classical" speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from "speculative" hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.

Keep in mind that Keynesians hold that "real rates" don't mean much, just as Keynes advocated inflation to cut real wages as a means to increase employment. His response was to declare that workers are only interested "in their money wage." History tells us something different, does it not?

On the Japanese recession, Krugman differs with Alesina and Ardagna on the timing and the forcefulness of the government's "stimulus" actions, yet his response is more technical than it should be:

First, the whole stimulus debate is supposed to be about what happens when interest rates are up against the zero bound. Everything is different if the central bank is busy adjusting rates in response to conditions, and may well raise rates to offset the effects of any fiscal expansion. Yet the Alesina-Ardagna analysis doesn’t make that distinction; Japan in the 90s, which was up against the zero bound, is treated the same as a batch of countries in the 70s and 80s, when interest rates were quite high.

Second, they use a statistical method to identify fiscal expansions — trying to identify large changes in the structural balance. But how well does that technique work? When I want to think about Japan, I go to the work of Adam Posen, who tells me that Japan’s only really serious stimulus plan came in 1995. So I turn to the appendix table in Alesina/Ardagna, and find that 1995 isn’t there — whereas 2005 and 2007, which I’ve never heard of as stimulus years, are.

However, as Doug French recently wrote, the Japanese government enacted a number of spending and interest-rate cutting actions during the 1990s, none of which worked. (True to form, Krugman several years ago claimed that had Japan's government not engaged in such actions, the Japanese economy would have fallen into depression, another "Heads, I win, Tails, you lose" proposition we often see from Krugman.)

Interestingly, Krugman always has approached the Japanese recession as having come out of nowhere, or he has linked it to Japan's high savings rate. French, however, notes that Japan had a huge and unsustainable boom that turned into a combination of stock and real estate bubble which popped:

For a brief moment in 1990, the Japanese stock market was bigger than the US market. The Nikkei-225 reached a peak of 38,916 in December of 1989 with a price-earnings ratio of around 80 times. At the bubble's height, the capitalized value of the Tokyo Stock Exchange stood at 42 percent of the entire world's stock-market value and Japanese real estate accounted for half the value of all land on earth, while only representing less than 3 percent of the total area. In 1989 all of Japan's real estate was valued at US$24 trillion which was four times the value of all real estate in the United States, despite Japan having just half the population and 60 percent of US GDP.

Bubbles, as we have seen, result from deliberate "expansionary" policies by government authorities, yet Krugman always seems to treat them as being solely the product of private enterprise. It never occurs to him that the policies of high leverage and betting on inflated asset values would not happen systematically if government were not acting behind the scenes. Instead, he tells us that the only thing that can rescue a financial system is a new round of government regulations.

Japan did not go into recession because of laissez-faire or because its citizens saved too much money, just as the Chinese did not cause our financial bubbles with their own savings. Krugman's response to the boom and bust cycle reminds me of something I saw written about a friend of mine: "The trouble with the world is wine, women, and song. We must stop singing."