Free Banking 

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.

Cross-posted from Coordination Problem.

This talk by Bank of Canada Governor Mark Carney from Thursday is of note mostly for the fact that he explicitly addresses both Austrian criticisms of central bank policy and the position taken by NGDP targeters like Scott Sumner.  The bit on the Austrians is below.  He does a decent job of explaining the argument, but a not so good job, I would argue, on what it implies.

Second, the stronger critique of the Austrian school is that inflation targeting can actively feed the creation of financial vulnerabilities, especially in the presence of positive supply shocks. For example, in an environment of increased potential growth resulting from higher productivity, inflation-targeting central banks may be compelled to respond to the consequent “good” deflation by lowering interest rates. From the Austrian perspective, this misguided response stokes excess money and credit creation, resulting in an intertemporal misallocation of capital and the accumulation of imbalances over time. These imbalances eventually implode, leading to crisis and “bad” deflation.

As I will argue later, this critique places monetary policy in a vacuum divorced from broader macroprudential management. Moreover, it offers only a counsel of despair for current problems: liquidate, liquidate, liquidate.

(For the NGDP crowd, there's plenty on that later in the talk.)

Clearly "liquidate" is part of the necessary solution, but it's not all and as many of us have tried to point out, it's not a counsel of despair.  It's instead a caution that central banks cannot solve the problems they created, any more than an arsonist makes a good firefighter.  It's only a counsel of despair if you think that central banks and and the rest of the government macro apparatus is the only process by which economic coordination takes place.  Getting out of the way of the millions of decentralized decision-making units who have to actively and creatively engage in recalculation and resource reallocation would allow them to initiate real recovery.  That's a counsel of hope if only we are humble enough to see it. And that, of course, is in addition to the necessary monetary reforms that move us toward a more decentralized competitive banking system.

It might seem strange that the boss of the Bank of Canada would feel compelled to address the Austrian argument.   Sure Austrian ideas are more in the air than they used to be, but it might help that the head of research at the Bank of Canada and chief advisor to the Governor is the father of one of my current students.  We've had him to campus to give a couple of talks and I've spent some time chatting with him (and his daughter was in my AEH course last fall).   The language of "good" and "bad" deflation is terminology that I have used quite a bit (George Selgin too), so I can't help but wonder if my connection isn't a contributing factor.  If not, then I'm guilty of no more than suffering from my usual case of inflated ego.

(Cross-posted at Coordination Problem)

I'm currently in Brazil at a summer seminar for young Brazilians interested in libertarian ideas sponsored by the Atlas Foundation and OrdemLivre.org in the beautiful mountain town of Petropolis outside of Rio.  On Thursday, I participated in a debate at the equivalent of the Chamber of Commerce in Sao Paulo celebrating the Mises-Brazil Portuguese translation of Ron Paul's End the Fed.  Around 70 people stuck around for almost 3 hours to listen to me give a 45 minute talk on why we don't need a central bank, followed by commentary and discussion from other participants.  The event was well-covered by the Brazilian press, including a nice story in the top economics paper in the country that included a picture pairing that I just loved (that's a Facebook link as I can't find it online).

There was also some TV coverage.  My bit is, in fact, in English.

It's amazing to think that a debate like this could draw this much attention in a part of the world not known for skepticism about central banking. That, I think, is a good sign.

In a piece titled "The Republicans' New Voodoo Economics?" Greg Ip writing in The Washington Post tries to connect up the current GOP with a whole variety of what he sees as wrong-headed ideas, including those of the Austrians.  What's most frustrating about the piece is his description of the Austrian view of recessions:  "Austrians considered recessions a natural feature of capitalist economies, and efforts to suppress them via monetary or fiscal policy were apt to distort investment, worsen booms and busts, or lead to inflation."

It's certainly true that Austrians believe that using monetary and fiscal policy will make matters worse, but Ip makes it seem as though recessions just appear from nowhere (a "natural feature of capitalist economies"), when the strongly dominant view among Austrians is that recessions are caused by government monetary policy via the central bank. This misrepresentation makes it look like Austrians are pure fatalists about recessions and their human toll, when in fact a great deal of ink has been spilled as to how better monetary institutions can prevent recessions in the first place, and obviate the exacerbation of those problems that comes from government monetary policy.  Ip's version of Austrian macro nicely fits into the now common narrative (see Lord Skidelsky's comments in the LSE debate and subsequently - see also George Selgin's brand new response) that Austrians simply don't care about trying to prevent recessions and minimize their human toll.  It also likely plays to the pre-conceptions the Post's readers have about critics of activist policy.

And yes, I'm well aware that Hayek argued that you can get the cycle without activism by the central bank, hence my language of "strongly dominant."  But in the larger rhetorical context, that's some intellectual hair-splitting when the vast majority of Austrian arguments about the source of recessions (rightly or wrongly) have focused on the expansionary policies of central banks.  Greg Ip is utterly unaware of these intra-school debates and his version of the theory is the result either of not bothering to engage with the actual work of the Austrians or intentionally fudging the theory to make it fit the narrative that drives the story.  Whichever it is, it's voodoo journalism.

Putting aside that it might be self-serving, the thing that really bothers me about so many media treatments of the Austrians, is that they focus almost solely on work written 75 years ago, making it seem like there's no modern work in the tradition and that Austrian arguments haven't been advanced and refined in light of subsequent criticisms and other schools of thought.  If journalists are going to discuss or interview living Keynesians and their work, then is it really that hard to Google "Austrian economics" and find some actual, living Austrians who have written on monetary and macro as part of your attempt to understand the role that these ideas might be playing in current policy debates? No one says journalists have to pay attention to Austrian ideas, but if they are going to do so, shouldn't they feel an obligation to talk to actual people who are working on the ideas? Not doing so seems to me to be another example of voodoo journalism.

Cross-posed from Coordination Problem.