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An Economist in Search of a Spine
April 20, 2010 Economics Problems

Parts of this piece from Nobel Laureate Paul Krugman accurately capture some of the difficulties facing policymakers as they think about bank “re”regulation. Here is an example:

A second version of reform calls for a full recreation of the Quiet Period banking system. We’ll reinstate Glass-Steagall, protect the depository institutions, and let the investment banks sink or swim.

Again, I don’t think this is realistic. Shadow banking isn’t going away. Like it or not, repo and other short-term debts now play a role in our economy comparable to that of bank deposits, and pretending that stabilizing depository institutions is enough just won’t fly.

Here, he seems to be operating in the real world for a change. I wished he would talk about why shadow “banking” arose in the first place – in response to the system of regulations arising out of the 1930s banking reforms – in particular limit in interest rates paid on deposits (Reg Q), restrictions on branching activity, and a multi-layered approach to regulation in the banking and financial sector at large (the OCC, the Fed, the state banking authorities, the SEC, the FDIC).  I wanted to point out three things about this Krugman piece.

  1. He offers up 6 narratives about problems in the banking system. They include size, shadows, opacity, predation, government intervention, and monetary mismanagement. Now, a responsible economist might say that no one or two of these narratives is correct. He might go on to say that each of the 6 had some part of the crisis, plus dozens of other factors that he did not list – and that simple narratives about our problems in the financial sector, are well, child’s play. He says nothing of the sort. And of course, which of the 6 narratives do you think he favors? Here’s a hint – if any of the narratives even hint that government officials might have had the smallest hand in the crisis – those narratives are rejected out of hand. That’s some yummy science from our resident Laureate.
  2. He never lays out for readers what the “banking” system really is. We have this weird system (perhaps) that conflates two things “banks” are tasked with doing. For me, the most important function of a bank is to keep the payments system working smoothly. Since the beginnings of 100% reserve warehouse banking several centuries ago, these organizations found that only a small portion of their reserves ever needed to be moved to close transactions – and hence the origin of fractional reserve banking. In other words, it made sense to combine the payments system with the intermediation system. Now, there are huge efficiencies to the banking system in doing this. But this is by no means necessary. There can very easily be a stripping out of the intermediation process from the payments process – and Krugman says not a word about this. In fact, bank “runs” in their traditional and modern forms, come ONLY as a result of the intermediation process. By conflating these issues, we can be opaque in our discussions of “quiet” banking and how regulations can emerge to recreate those quiet conditions. The intermediation process has never been quiet and it is an open question whether and how much governments should intervene in that process.
  3. Here is what counts for “analysis” from a Nobel Laureate. If you see a point you don’t like made by opponents, you say, “I won’t spend time on this, it’s easy to refute.” And then move on and say nothing to refute it. He mentions the narrative that some believe the Community Reinvestment Act was a driver of the subprime crisis. Now, I do not subscribe to that view (it is too small and too simplistic) but I certainly do not think the CRA, along with dozens of other reforms and regulations and oversights (and greed too) should be exonerated because none, by themselves, were large enough to cause problems. But here is how Krugman chooses to exonerate the role of the CRA,

“The CRA was around for almost 30 years before the problems in subprime began to develop; anyway, most subprime lenders weren’t even covered by the act. And the worst of the housing bubble developed at a time when Fannie and Freddie, under pressure over accounting scandals, were actually withdrawing from the market.

Oh, isn’t that cute. Since the CRA was around for 30 years before the crisis, it hardly could be blamed for ANY part of the subsequent sketchy housing investments that were made. Then I guess Paul would agree to the following, “since free markets were around from 1789 until the Great Depression started, it couldn’t possibly be the case that free-markets had anything to do with the Great Depression.” Or pick a better analogy. My 4 year old could come up with better analysis than that. “Toyota was around for 40 years before the problems with safety began to develop; anyway, most drivers do not drive Toyotas …” does that sound any better?

It’s quite clear that Krugman has a preferred view of the world, and just as he argues (correctly) that “nothing will convince Republicans that Barney Frank did not cause the crisis” well, there is nothing that could ever possibly be presented to Krugman to convince him that bad government, bad regulation, misaligned incentives, playing with other people’s money, the marriage between Wall Street and the Executive and Legislative Branches, etc. had anything at all to do with the crisis either. That’s fine. Just don’t dress up what you are doing as some sort of unbiased, cold, calculating economics.

"2" Comments
  1. The fact that Krugman still gets to be called an economist instead of a leftist/statist shill is distressing to me.

  2. Every once in a while, Krugman makes some sense, but he usually goes on to contradict that sense in the next sentence. But I was sent these articles where Krugman must eat hs own words.
    “Krugman’s Intellectual Waterloo”
    http://mises.org/daily/3530
    “Krugman’s Rearguard Apologists” (responding to criticism of the previous article)
    http://mises.org/daily/3539

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