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Steven Horwitz
In his NY Times column Sunday, Paul Krugman tries, in vain, to construct a case for bank regulation in light of the problems at JP Morgan. As usual with Krugman, there's much to disagree with, but I want to focus on his utterly ham-handed version of the history of US banking, which bears shockingly little resemblance to reality.
Krugman thinks he has the critics of regulation nailed with his take on US financial history:
Why, exactly, are banks special? Because history tells us that banking is and always has been subject to occasional destructive "panics," which can wreak havoc with the economy as a whole. Current right-wing mythology has it that bad banking is always the result of government intervention, whether from the Federal Reserve or meddling liberals in Congress. In fact, however, Gilded Age America "” a land with minimal government and no Fed "” was subject to panics roughly once every six years. And some of these panics inflicted major economic losses. 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.
This passage is an utter abuse of history in several ways.
Most important, what Krugman calls the "right-wing mythology" is largely correct: government intervention is responsible for the systematic problems with the US banking system. That, however, is not the same as "bad banking." Banks, like any other business, make mistakes all the time. Bad banking happens in free markets, but markets provide incentives and knowledge signals that help banks avoid and correct such mistakes. The question is not whether there is or isn't "bad banking," but which institutional environment minimizes and corrects it best. What doesn't happen in free markets are the systematic mistakes that lead to panics and massive bank failures.
And that is where Krugman is most wrong. What he calls "Gilded Age America" was emphatically not a land of minimal government in banking. Yes there was no Fed (and no serious critic of regulation has blamed everything on the Fed), but the federal and state governments played a huge role in the banking industry and it was those regulations that were responsible for the pre-Fed panics. The two most relevant regulations were: 1) the prohibition on interstate banking, which created overly small and undiversified banks that were highly prone to failure; and 2) the requirement that federally chartered banks back their currency with purchases of US government bonds, which made it prohibitively expensive to issue more currency when the demand rose, leading to the currency shortages and resulting panics that culminated in the Panic of 1907.
These were not failures of a free market in banking. They were failures of government regulation. And those same restrictions on interstate banking, along with the failure of the Fed to do its job, were largely responsible for the massive failures of the 1930s. Banks during the Great Depression were hardly unregulated, and those bank failures happened after the creation of the Fed. Those banking problems were also failures of government regulation.
But Krugman has a much bigger puzzle to explain away: if free markets in banking are the problem, why did Canada, which, during this period, had a far less regulated banking system than the US, not experience the panics we did, and why did no Canadian banks fail during the Great Depression while around 9000 US banks did? If Krugman's criticism of the "mythology" is correct, the Canadian banking system of that era should have been a basket case, but instead it was a model for the world precisely because it lacked the two most damaging government regulations present in the US. Canadian banks have always been free to operate nationwide and were, before 1934, able to issue their own currency free of bond collateral requirements. The very free market in Canadian banking dramatically out-performed the much more regulated US system.
So Professor Krugman, what say you? If the reason banks fail is because free markets in banking don't work, how do you explain the lack of the problems you claim plague free markets in the much less regulated pre-1934 Canadian banking industry? The mythology, Professor, is your history, not mine.
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Canadian banks didn't fail or need huge bailouts in 2008 either, but this time round finance was much _more_ regulated in Canada than in the US. Maybe it's just something about the air over there.
Two honest questions from an underinformed commenter, and one comment:
1. So did state chartered banks not fail at the same rate as national banks in the earlier panics? If the bond collateral requirements were the issue, that's what you'd expect. As a Keynesian, Krugman should have no trouble whatsoever accepting that bond collateral requirements are just as much a barbarous relic as the gold standard (the gold standard also being a "government regulation", of course).
2. On the Canada comparison, it seems to me that if you're comparing a branching system to a non-branching system what you'd want to look at are establishment failures, not firm failures. If Canada's banks branched certainly you'd expect less failure of the banks themselves. Does that mean that less actual establishments closed? Or more importantly, does that mean that the money supply constricted less during these panics?
And a comment:
Canada went off the gold standard in 1929, no? That seems very relevant to the story of how they fared in the Great Depression - arguably more relevant than the other regulations.
Oh - and I can't help but point out - the bond collateral requirements of course would not be so onerous if the federal government were doing its job w.r.t. fiscal policy. This is largely the point of fiscal policy now: to make that particular investment vehicle plentiful.
Daniel,
1. The comparison isn't pure because the state-chartered banks faced a 10% tax on their issues of banknotes, imposed by the Civil War Congress when the realized no one would take a federal charter (and thereby buy up the bonds to fund the war) unless there was a reason. State-chartered banks were also subject to similar bond-collateral requirements, and in some cases those were railroad and other private sector bonds.
I don't know if the failure rates were higher, but the important point is that the state-chartered banks were subject to many of the same regulations plus the tax on note issue, so it's not clear what any difference would show.
2. Yes, Canadian offices closed, though not nearly to the extent that US banks failed. But so what? If you hold a bank liability, there's a huge difference between the inconvenience of having to do your banking in the next town (or at a different branch in the city) and your bank being insolvent and unable to fully pay what it owes. That difference is exactly the reason to prefer branched systems.
re: "But so what"
Right - I agree. That's why I added the point about the money supply, which is the real issue. Bernanke would argue that there is critical local knowledge lost when offices close, but presumably the money supply is the more critical point, not the bank failures themselves.
Oh I meant to link to this too on the money supply: http://www.jstor.org/discover/10.2307/1828909?uid=3739936&uid=2129&uid=2&uid=70&uid=4&uid=3739256&sid=47699001417527
It looks like it did not drop as precipitously as in the U.S. (although the hit to GDP in Canada was still substantial). But then, that makes me wonder whether this is a function of banking regulation or the fact that they left the gold standard.
Don't forget the backing of railroad bonds by the government, leading to the same sort of moral hazard scenario that resulted in the Panic of 1893.
I suspect--and this is being charitable--that Krugman looks at "regulation" the same way he looks at "spending." All that matters is the size of the aggregate, and he really can't be bothered with what the details are. He doesn't seem to believe that details matter, or at least that small, structural details are largely irrelevant to large-scale phenomena. So when he looks at the two eras, all he sees is the difference in the quantity of regulations. Therefore, 19th C panics were caused by "low regulation," and the only way to stop financial crises is with "high regulation." He's self-blinded to what the individual regulations are, because it's not something that he thinks matters.
The idea that ten pages of really bad, deeply structural regulations can destabilize a banking system as badly or worse than a thousand pages of trivial regulations isn't really in his intellectual toolbox.
Yes, Canada was not hit by the GD in quite the same way as the US, mostly because they avoided both the awful monetary policy as well as the bad labor market policies. They had trouble in agriculture, but even there it didn't translate into a collapse of the banking system the way it did here.
As I said on FB yesterday, PK smugly scoffed at the idea of TV debates on econ because it's so easy to spew nonsense and play loose with narratives with no real room for deeper counterarguments and clarity. But when given an op-ed article to make a larger case for a national audience, he does just that.
I am no expert on this stuff but having read various articles in the past from the likes of Robert Higgs and others about the specific anatomies of the 19th Century/Early 20th Panics, PK's quick, self-serving account of those Panics struck me as unbecoming of a PhD in economics as soon as I read it. It reads more like material from a college freshman with a bone to pick or an activist journalist who doesn't know up from down.
He may be no expert in economic history but he's still an economist and should know better about these things regardless of his area of expertise. And it obviously wasn't a question of time or space constraints since you managed to shed some light on the matter within a few sentences. Shame on PK and those who rationalize or defend him on this. (Cough, DK, Cough)
I'm not sure you need to go around shaming people, John V. I was just asking a few questions that came to mind after reading this informative post. You realize that one can simultaneously entertain questions about both Steve's case and Krugman's case, don't you?
FWIW The United States has what is probably the most highly regulated financial sector in the world. Europe does not even come close in terms of regulation. Check out: James R. Barth, Gerard Caprio Jr., and Ross Levine, The Regulation and Supervision of Banks Around the World: A New Database, The World Bank Development Research Group Policy Research Working Paper 2588 (2001)
I also highly recommend Monica Prasad's work on the Credit/Welfare State Tradeoff to help explain why the "liberal" US has so much bank regulation.
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