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?

Washington, D.C.: The REAL Oligarchy

Back from Iceland, Paul Krugman now takes on what he calls the Oligarchy, but as usual, he points his guns in the wrong direction. According to Krugman, we have huge amounts of income inequality that is destroying U.S. society because, according to him, the State does not have enough power.

(Since Krugman's annual income literally is in the millions of dollars, I am not sure why he does not blame himself in part for the problem. After all, if according to his Keynesian doctrines, wealth only can be distributed, not created, then Krugman is as big a thief as he accuses others of being.)

Readers can look at the column and draw their own conclusions, but it seems to me that Krugman has missed something that tells the REAL story about our economic plight: the least-productive and most parasitic area of the country -- Washington, D.C., and its immediate environs in Maryland and Northern Virginia -- is also the highest-income locale. Let that one sink in, folks.

No doubt, a number of readers of this blog will be enraged by what I am writing. Washington not productive?!? Why, no one spends more than those who inhabit the nation's capital, and every Keynesian knows that the most productive thing anyone can do is to spend, spend, spend.

Indeed, according to the Keynesians, Washington is SO efficient in its spending that it is making the rest of us better off via the vaunted Keynesian multiplier. Furthermore, Washington with its regulatory and lawmaking power is able to create huge barriers to economic growth, confiscate property (and redistribute it among those who live there), and then get its shills like Krugman to claim that others are to blame.

It is Washington that forces us to put ethanol into our cars, damaging the engines and lowering gas mileage; it is Washington that creates regulations that benefit the least productive people at the expense of those that are productive. It is Washington that has created thousands of new criminal laws that are so expansive that most readers of this page have committed at one time or another felonies that could land them in prison -- yet were not even aware that they were breaking the law.

(The courts in Washington have ruled that every citizen is responsible for knowing every law and every regulation that comes out of the city. There are exceptions, however: prosecutors, judges, and the police do not have to know the law and are not punished when they break it, especially out of ignorance. "Ignorance of the law is no excuse" applies only to those of us who are not employed carrying out the law.)

I agree that Wall Street has been out of control. This blog has long dealt with those issues regarding finance and the symbiotic relationship between Washington and the banks, but let us also keep in mind that both the Republicans and Democrats have seen Wall Street first and foremost as a cash cow for campaign contributions are are desperate to keep the spigots flowing.

Yet, when Wall Street goes over the cliff, Washington forces the rest of us to rescue the bankers instead of permitting people to bear the consequences of their own actions. But what is Krugman's "solution"? It is to expand the moral hazard that Washington creates, and to force taxpayers to pony up and finance disasters like Solyndra. (And Krugman has defended the Obama administration's funding of this firm, as has his employer, the NYT.)

So, let us be frank here. Paul Krugman is not against an "oligarchy." Indeed, he absolutely supports Washington becoming wealthier, and according to his Keynesian doctrines, the more Washington confiscates our wealth, the better off we are.

Krugman and his Kindred Spirits: Supporting the Ruling Class

I was wondering when Paul Krugman was going to start praising the "Occupy Wall Street" protests, and he finally is getting on the bandwagon. And like about everything else Krugman does these days, he manages to write commentary without a shred of insight and once again make the claim that if we provide enough of "something for nothing," we can ride that nothing to an economic recovery. Fat chance of that.

Anthony Gregory of the Independent Institute, one of the best young libertarian writers today, has a much more insightful piece, and I link it here because, contra Krugman, Gregory actually understands that governments cannot borrow and print us into prosperity. Gregory notes:

Although there is no single ideology uniting the movement, it does seem to have a general philosophical thrust, and not a very good one at that. OccupyWallStreet.org has a list of demands, and while the website does not represent all of the protesters, one could safely bet that it lines up with the views of most of them: A "living-wage" guarantee for workers and the unemployed, universal healthcare, free college for everyone, a ban on fossil fuels, a trillion dollars in new infrastructure, another trillion in "ecological restoration," racial and gender "rights," election reform, universal debt forgiveness, a ban on credit reporting agencies, and more power for the unions.

In other words, the leaders of the Occupy movement want out-and-out dictatorship, as that is the only thing that can claim to order these things into being. In the world of Paul Krugman and his Occupy friends, government by fiat can overturn laws of science and economics and tax, borrow, print, and spend us into "prosperity."

In this world, only the State produces anything. Do we want "infrastructure?" Hey, no problem! Devote a trillion dollars to it (coming from nowhere) and it will magically appear. Do we want to do away with coal and oil and natural gas? No problem, Mon! Just make the order and we can have "clean, green energy" by fiat. Why bother with laws of science and economics when we can create a "New Science" and a "New Economics" by executive order?

For all of the "change" that Krugman and the Occupy crowd are demanding, I agree with Gregory that the Ruling Class of Washington, D.C., truly has nothing to fear from these folks. The most parasitic people among us are the ones being championed as our heroes and avengers, and I have seen nothing from the Usual Suspects leading this latest "movement" that leads me to believe that what they want is an Obama dictatorship on steroids.

Judge Andrew Napolitano, who I am sure is one of the many people on Krugman's "Hate List," warns that government is subject to all of the natural laws that bind the rest of us. That is something that gets past the Krugman and Occupy crowd.

Has there been misconduct on Wall Street? Yes, but the remedy was there three years ago: let the banks and financial houses that "invested" in the "toxic assets" take the bankruptcy haircut. The market would have meted out its "justice" for the stupid decisions they made.

Instead, it has been the government itself that has propped up the bad decisions, with the government -- and especially the Obama administration -- adding even worse decisions every day. However, from what I can tell, Krugman and the Occupy crowd are not satisfied and want out-and-out dictatorship, because ONLY a dictatorship can order what Krugman and company are demanding.

And, in the end, when that fails, who will Krugman blame? I'm sure that he can find his Goldstein, as he is quite good at doing that.

I think I understand why Krugman never has mentioned Steve Jobs in any of his posts or columns. Jobs did not "invest" in giving money to politicians, and he violated the Law of Krugman by saving money and developing products. After all, everyone knows that such things only hold back the economy, which can only move forward when governments implement inflation and other measures of "aggregate demand."

Thus, to people like Krugman, entrepreneurs like Jobs are nothing but parasites. They get rich and don't spend the money where Krugman wants it to be spent. They encourage people not to become bureaucrats or even economists. Furthermore, they don't even finish college; they just DO something, and that is unacceptable in the Wonderland of Krugman.

Yeah, it was Lehman all along!

One of the prevailing myths that seems to keep going like the Energizer Bunny is that the financial meltdown occurred because the Bush administration let Lehman Brothers fail. Yes, this was a major event, the biggest bankruptcy in U.S. History, yet the economy did not go down because Lehman failed, no matter what Paul Krugman might say. And he says:

I’m puzzled: shouldn’t the papers this morning be full of retrospectives about The Event That Ended The Economy As We Knew It? (Not to mention the event that guaranteed an Obama election win.)

Or have the financial media decided to go along with the prevailing public view that none of this happened until after Obama was inaugurated?

While this is a short post on Krugman's part, nonetheless it is full of the usual fallacies he likes to promote. First, and most important, the economy did not go down because Lehman failed; Lehman failed because it had been a major player in promoting an unsustainable boom, and during the boom, it profited well, and when that toga party came to an end, so did Lehman's profitability.

Second, a rescue of Lehman by stuffing its assets full of funny money from the Federal Reserve System would not have changed the fundamental picture a whit. Wall Street was in trouble because its balance sheets were unbalanced, not because the Fed had failed to create enough new dollars. Lehman had bet the house on the housing market and lost.

Furthermore, had the Fed and the Bush administration let the banks and financial houses that were unsound go under, yes, the original economic downturn would have been steeper than it was. However, there were healthy financial houses and there were a lot of healthy assets in the economy, and they would be leading us in a recovery right now.

Instead, the government, first under Bush and then under Obama, decided to paper over the holes in the asset framework with Monopoly Money as though there had not been a massive amount of malinvestment occurring. As we have seen, we now have no recovery and the future is grim.

So, Happy Lehman Day to all of us. It would have been happy had Henry Paulson not demanded that taxpayers and the Fed bail out his good friends.

Lew Rockwell on Keynesian "Inception"

One thing I like about Lew Rockwell is that he has an uncanny way of explaining things in ways that anyone (except, perhaps, a Ph.D. economist) can understand. There is no wonkishness, no equivocating, and certainly no appeal to the God of the State.

His latest article, "The State's 'Inception' Fails," is an excellent case in point, and I urge readers to find out for yourselves why I believe this commentary is on the mark. Lew writes:

Two years ago, the economy was seriously dragged down amidst an amazing banking crisis that spread throughout the world. The illusion created by loose credit – that housing could go up in price forever and we could enjoy permanent prosperity due to monetary expansion – was shattered by events. Reality had dawned. We found ourselves in the midst of an economic depression.

At that point in policy, we were at a fork in the road. The wise direction was to let the depression happen. Let the bad investments wash out of the system. Let housing prices fall. Let banks go broke. Let wages fall and permit the market to reallocate all resources from bubble projects to projects that make economic sense. That was the direction chosen by the Reagan administration in 1981, and by the Harding administration in 1921. The result in both cases was a short downturn followed by recovery.

The Bush administration, in a policy later followed by the Obama administration, instead attempted a tactic of dream incubation as portrayed in the recent film Inception. The idea was to inject artificial stimulus into the macroeconomic environment. There were random spending programs, massive buyouts of bad debt using phony money, gargantuan tax tricks, incentive programs for throwing good money after bad, and hiring strategies to weave illusions about how all is well.

His reference to "Inception" is quite accurate, and his explanation clearly explains his analogy:

In the movie, the goal of the dream incubation was to implant an idea into an unsuspecting subject’s head that would cause him to act differently than he otherwise would have. In the real life version of inception, the state tried to implant in all our heads the idea that there was no depression, no economic collapse, no housing crisis, no push back on real estate prices, and really no serious problem at all that the state cannot fix provided we are obedient subjects and do what we are told.

In the movie version, the attempted inception is on a time clock. The dream weavers can only keep the subject in a state of slumber so long. In the real life version, things are much messier. The headlines have spoken about the impending recovery every day for all this time, and yet the evidence has never really been there. All the stimulus really did was forestall events a bit longer, but it hasn’t prevented them.

Now, with the stock markets melting and the near-universal consensus that we are back in recession, everyone is awake. It is pretty clear that the inception did not take. The unemployment data look absolutely terrible. As the Wall Street Journal points out, only 59% of men age 20 and over have a full-time job (in the 1950s, that figure was 85%). Only 61% of all people over 20 have any kind of job now.

Unfortunately, the "educated" people like Paul Krugman and Ben Bernanke, while disagreeing on some of the details of what government policies should be, nonetheless share the same general view: Only government spending can bring back the economy through artificial "stimulus." Unfortunately, these people have misunderstood what an economy really is and how it works. Like other academic economists, they see an economy through mathematical equations in which there really is no purposeful human action.

Instead, the automons produce goods on one end and then "buy back" what they have produced, which makes no sense from the larger point of view. It creates a view of people who simply go through the same motions day after day, and if they do it enough times, the economy gains what Krugman likes to call "traction," which then permits this process to go on somewhat rhythmically. If the individual does not spend in the patterns that the academic economists declare are necessary for this "traction" to continue, then the consumer somehow is "falling down on the job."

With the "Ruling Class" economists and politicians, there always is someone else to blame. The "stimulus" was too small; consumers are greedily saving their money instead of dishing it out at the stores and in auto showrooms; businesses refuse to engage in long-term spending and investment; banks are sitting on reserves; or Republicans (though is a huge minority in Congress) are keeping President Obama from carrying out his proper duties just as Goldstein constantly thwarted the aims of Big Brother.

Unfortunately, this administration -- like the one that preceded it -- is refusing to face reality and continues to believe in its "inceptionist" tactics. However, an economy is not an imaginary construct; it is a real entity and its success depends upon the ability of entrepreneurs and producers to make those goods that people need, something that always will escape the understanding of the supposedly "best and brightest" among us.

Yes, Paul, I Agree: The Rating Agencies ARE Corrupt

In his column today, Paul Krugman takes on the Rating Agencies, such as Moody's, that were giving AAA marks to sub-prime debt that turned toxic. His comments here are on the mark:

Let’s hear it for the Senate’s Permanent Subcommittee on Investigations. Its work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation. In the past few days scandalous Wall Street e-mail messages released by the subcommittee have made headlines.

That’s the good news. The bad news is that most of the headlines were about the wrong e-mails. When Goldman Sachs employees bragged about the money they had made by shorting the housing market, it was ugly, but that didn’t amount to wrongdoing.

No, the e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

What those e-mails reveal is a deeply corrupt system. And it’s a system that financial reform, as currently proposed, wouldn’t fix.

He is right about the out-and-out whoredom of the agencies and I also agree that Financial Reform as is being touted right now would not solve the problem.

The issue, however, is why the once-staid and sober Moody's and Standard & Poors turned into a bunch of financial drunkards in a relatively short period of time. That is where Krugman and I differ.

As an economist, when I see something perverse like what happened, I look for the underlying reasons, and especially the structure of incentives that helped bring about this whole regime change in how the agencies went about their business. While I am sure Krugman gives lip service to incentives, he prefers the Keynesian line about "deregulation," which tends to be the ideological umbrella under which he works.

A friend of mine who is a first-rate accountant said that mortgage bankers told her that what seemed absolutely silly and reckless after the bust made perfect sense when the easy money regime was ruling. This is vital to understanding the boom-and-bust, as Austrian Economists point to the actions of the Federal Reserve System holding down interest rates and flooding the markets with credit.

Now, Krugman at the end does give lip service to incentives, but he still misses the bigger picture. Had the Fed not been reckless with interest rates and dumping credit everywhere, the incentives for the ratings industries would have been different, period. As Peter Schiff said last year, "The whole country was drunk." The real question, he asks, is who brought the booze.

This is where Krugman and the Austrians differ. We believe that if the Fed is not playing the credit sugar daddy, the incentives that run with an easy money financial regime will not be there. (This is not excusing Moody's and S&P for not doing their jobs, but rather giving a reason as to why they took flight from sound finance.)

Krugman, on the other hand, believes that the Fed should continue providing the liquor, but the regulators will tell Wall Street when, where, and how much to drink. This is a recipe for later problems that will be worse than what we are facing now.

Well, Paul, What Did You Expect With the Bailouts?

Poor Paul Krugman. Here we had the government stepping in to "fix" the mess in the financial markets, and this is a government that is run by his fellow Progressives. Yet, Krugman sees doom. Hmmm.

In "The Secret of the Banks' Success" on his blog, Krugman writes:

Back in early 2009 I was skeptical about the ability of major banks to recapitalize themselves out of profits. I was wrong, it turns out. Here’s why: Financial-industry profits have soared, probably because banks that can borrow money cheaply — because they have an implicit guarantee from the feds — are more or less guaranteed money machines unless they do something stupid; and gross stupidity has been placed temporarily on hold.

This has been good for the TARP, which won’t lose much money.

Beyond that, however, I find this ominous. We got into this mess because we had an over-financialized economy, with finance making a share of profits out of all proportion to its actual economic contribution. And now it’s baaaack.

If Krugman were to talk to the Austrian Economists -- a group he holds in total contempt -- he might find that the better road would have been for there to be no TARP at all.

The very best thing that could have happened to Wall Street, which was exposed by the free market for being over-leveraged and its executives overpaid, would have been to let some people besides Lehman go out of business. As Peter Schiff asked in a great speech last year, "Why do we need Goldman Sachs?" Indeed, why do we need a lot of the very players with the Ivy League pedigrees who brought down our economy, yet made a bundle in the process?

Instead, we now have the same people even more politically entrenched than before, who understand that beyond all else, as long as they give political contributions and agree to appear at a D.C. show trial or two, they have free reign for as long as they want. It's a great deal for them, but lousy for everyone else.

Krugman seems to understand that point instinctively, but because he apparently does not believe in the established "Capture Theory" of Regulation, he is not going to understand why the regulatory regime that he wants exists only in his imagination.