Will Krugman ever get anything right?

Paul Krugman, who predicts economic Armageddon after another in the hope he'll eventually be right, did a curious thing in his new op-ed "Partying Like It's 1929": he didn't blame George W. Bush or Republicans, contrary to his norm. But as is his norm, he demonstrated a lack of awareness of real economics and history.

If Ben Bernanke manages to save the financial system from collapse, he will — rightly — be praised for his heroic efforts.

But what we should be asking is: How did we get here?

Why does the financial system need salvation?

The opening is mild enough, if you put aside that Bernanke is hustling along the inflation and deserves no accolades for anything.

Why do mild-mannered economists have to become superheroes?

Those of us who understand Krugman know that here he's not just talking about Bernanke, but about himself too.

The answer, at a fundamental level, is that we’re paying the price for willful amnesia. We chose to forget what happened in the 1930s — and having refused to learn from history, we’re repeating it.

This is true to some extent, but only because Krugman is making generalities. It's not completely true, semantically, because most people today, especially lenders, never understood the problems of the 1930s and hence could never have chosen to forget it.

Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931.

As an academic, "one would think" Krugman would know enough to be more precise in his phrasing. (I put "one would think" in quotes because it's a common rhetorical trick Krugman uses, to imply an absolute with which no one can disagree.) Just what does Krugman mean by "defining moment"? It's a ridiculous cliché, and most often used to reference time periods too long to properly be called a "moment." Krugman really wants to reduce two years to a "moment"? Well, when he fudges numbers to prove his agenda, why should we be surprised when he fudges language too?

But let's play Krugman's game, both with his imprecise use of "defining moment" and his assumption that it was "the wave of bank runs." The American economy had already slipped into a recession about in August 1929, but it wasn't quite apparent to the regular American. At the end of October 1929, however, most Americans knew something was wrong. Is Krugman really suggesting that news about the crash, and neighbors jumping out windows, also didn't "define" for Americans (or however he's using "defining moment") that the economy was in trouble, that it was the bank runs that didn't occur for several more months?

Or is Krugman merely trying to correlate modern events with past events, fudging historical details just like he does with numbers and words?

This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure.

If Krugman isn't blaming Bush and/or the GOP, it's a safe bet he's at least blaming the free market. Thankfully we had Milton Friedman to tell us that it was the Federal Reserve that directly caused the Great Depression by sparking and fanning the initial financial crisis. The economy was already under strain in the late 1920s; the last thing it needed was a deflationary shock. This isn't natural, mild deflation that my friend Josh Hendrickson has talking about, but a massive slashing of the money supply, far greater than anything possible under the free market during the same period of time, that confuses borrowers and lenders alike, preventing them from making the right decisions.

There was a mild, lesser-known recession in 1927 to which the Fed responded, but in 1928, the Fed already began tightening monetary policy. It "raised the discount rate from 3.5% to 5%. Because nominal prices were falling, the latter translated into a real discount rate of 6%, which is quite high in a year following a recession." Now, some erroneously claim that the Fed was even trying to expand the money supply. That argument ignores that when the Fed "made major purchases of U.S. securities, and cut interest rates from 6 to 4 percent," that still didn't undo that the Fed had previously sold three-quarters of its Treasury holdings, and that interest rates were higher than when the Fed started! So let's not emphasize the bank failures themselves, which are merely a symptom. The cause was the monetary policy that affects all banking operations.

The Fed didn't reveal to the public precisely what it was doing, so its monetary machinations confused buyers and sellers in any market. People knew something was wrong, but everyday people can't readily perceive that there are fewer dollars going around. What people at the time did know was that big layoffs were taking place, and those who couldn't find new jobs in time had to, naturally, tap into their savings. Their expectation was that they can withdraw a dollar at a dollar's value. It's true that banks lend out most of their savings at any given time, but it was more than millions of Americans trying to pull their money out at once. The sum of their claims exceeded what was now there: eventually the Fed's actions reduced the money supply by nearly a third.

If the money supply is cut, most prices can adjust as sellers become aware. Deflation increases a currency's purchasing power, so prices will go down. Wage earners can be paid less, and in fact must be, because sellers must cut prices. This, though, is a problem for borrowers and lenders. Deflation means that as people earn less, they'll find it harder to repay existing loans -- not inherently bad if it's natural, but the deflation of the Great Depression was artificial, not to mention much larger than anything naturally occurring. Today, we just can't conceive the havoc of having to repay loans with a money base only two-thirds of what it was.

You may wonder why I've been talking about this for four paragraphs, to counter just one line, but it's to demonstrate that by a simple examination of history, Krugman is flatly wrong to blame the "free market" for the banking problems.

As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way.

Krugman is correct here, but again, only because he's speaking so generally.

To grasp the problem, you need to understand what banks do.

If there's one thing we've learned from Krugman over the years, it's that we should be skeptical of what he says, especially when he assumes this smug "professor" tone.

Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment.

Krugman's explanation is unnecessarily complex. Banks are simply "brokers," middlemen who create a marketplace where buyers and sellers can come together. The sellers are those who wish to lend, and buyers are those who wish to borrow.

Krugman's explanation is also partly wrong. It's based on the liberal myth of "zero-sum" (that if someone gains, someone by definition must lose). The desires of borrowers and lenders are actually no more "conflicting" than a deli's desire to earn money conflicts with my desire to buy lunch. Borrowers wish to borrow money at a certain premium, and lenders wish to get a return on money they cannot touch.

He's furthermore wrong in his explanation of what savers and borrowers want. Savers don't necessarily "want freedom — access to their money on short notice." Savings are often tied up and cannot readily be liquidated at face value, which savers accept when they invest in instruments of a clearly specified duration (CDs, bonds, notes, etc.). Conversely, borrowers do "want commitment" in a way, but when Krugman says "they don’t want to risk facing sudden demands for repayment," it's meaningless because it's obvious. Loans are made on terms, whether mortgages, auto loans, credit card and other revolving loans, even margin calls. What borrowers do want is assurance that they won't have to pay back more than what the contract says, or pay it back earlier than specified.

After spending three short paragraphs explaining bank runs (which is correct because he kept it simple), Krugman praises intervention:

That, in brief, is what happened in 1930-1931, making the Great Depression the disaster it was. So Congress tried to make sure it would never happen again by creating a system of regulations and guarantees that provided a safety net for the financial system.

Indeed! The Federal Deposit Insurance Corporation, coupled with Fed action (to "inject liquidity" however and as it deemed necessary), successfully prevented bank runs. It did not, however, eliminate the fundamental problem of banks making bad loans. The very existence of the FDIC, coupled with the promise of central bank action, created a moral hazard. Banks were hardly discouraged from making riskier loans than if they had to eat the losses, and moreover, the implicit promise of a bailout encouraged them to make riskier if not corrupt loans -- whether the S&L bailouts two decades ago, or the subprime situation now.

Ultimately, "safety net" means that the responsible American is made to pay for the sins of the irresponsible, which is in line with Krugman's collectivism.

And we all lived happily for a while — but not for ever after.

Wall Street chafed at regulations that limited risk, but also limited potential profits. And little by little it wriggled free — partly by persuading politicians to relax the rules, but mainly by creating a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

Do you see? Like above, Krugman isn't talking about preventing problems, only lamenting that they weren't FDIC-insured, which is the same to wish that "If only the federal government were responsible for bailing these people out."

The Federal Deposit Insurance Reform Act of 2005 and its followup Federal Deposit Insurance Reform Conforming Amendments Act of 2005 set a top limit of the Deposit Insurance Fund at 1.5% of all insured deposits. That means anything over 1.5% is shifted to the American taxpayer. That prompted Congressman Ron Paul to warn about the Reform Act in 2005 from a practical perspective as well as constitutional: "In the event of a severe banking crisis, Congress likely will transfer funds from general revenues into the Deposit Insurance Fund, which would make all taxpayers liable for the mistakes of a few."

As we've seen, though, the federal government didn't need the Act or anything similar to bail out the S&Ls in the late 1980s and early 1990s. Today, Krugman wants it to happen again with those who invested in mortgage-based securities, or at least laments it can't happen by the FDIC? Why should the rest of us pay for the foolishness of others? Anyone who shifted investments to CDOs did so deliberately, and with the knowledge they could lose value. Just like stocks, corporate bonds, etc., CDOs simply aren't covered by the FDIC, and investors knew that every time they looked at a prospectus. If they didn't bother to look at a prospectus, well, that's their fault.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned.

Until now, I thought even Krugman knew that if you wanted to earn maximum returns, you had to accept maximum risk. Why should collateralized securities be considered "safe" and thus subject to a taxpayer-provided bailout?

In fact, however, we were partying like it was 1929 — and now it’s 1930.

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting it into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

After talking about the evils of this "shadow banking system," why isn't Krugman happy that people are getting out of it? After all, he shouldn't be calling it a crisis, but a correction.

In fact, Krugman should be delighted that this gives the federal government more money to spend, and that those evil capitalist bankers have less capital available. The rest of us know that the way the federal government spends, our money is far more at risk of being wasted by Washington than being lost in CDO investments.

Mr. Bernanke and his colleagues at the Fed are doing all they can to end that vicious circle. We can only hope that they succeed. Otherwise, the next few years will be very unpleasant — not another Great Depression, hopefully, but surely the worst slump we’ve seen in decades.

Even if Mr. Bernanke pulls it off, however, this is no way to run an economy. It’s time to relearn the lessons of the 1930s, and get the financial system back under control.

Ron Paul also said when opposing the Reform Act, "Immediately after a problem in the banking industry comes to light, the media and Congress inevitably blame it on regulators who were 'asleep at the switch.' Yet most politicians continue to believe that giving more power to the very regulators whose incompetence (or worse) either caused or contributed to the problem somehow will prevent future crises!"

Similarly, Krugman expects the Federal Reserve and the federal government, the very engineers of the current financial crisis, to "fix things"? It was the Federal Reserve that caused the Great Depression, the stagflation of the 1970s, the 1990-91 recession (look at the rates from the late 1980s through 1990 and tell me what 8% and 9% FFRs will do for economic growth), the 2001 recession, and now the subprime mess. I had the pleasure of meeting Bruce Bartlett a couple of weeks ago, and one thing we talked about was our central bank. As he so well put it, "The Fed always overdoes it." It tightens too much, or loosens too much. I'll add that it creates bubbles and pops them.

Then there's the federal government. Besides the moral hazard of bailouts, it pushed mortgage lenders to lend more money to minorities. Stan Leibowitz wrote an excellent history of how ACORN complained in the 1980s that low-income minorities weren't getting as many loans. The fact that banks rejected loans on the basis of ability to repay, not race, didn't deter Congress and the Clinton Justice Department from using legislative and executive blackmail to force lenders to make less unsound loans. It turned out, not surprisingly to those of us who understand market forces, that banks didn't want to make the loans because of the high risk they wouldn't be repaid. Yet the liberal media turned this into headlines like, "Minorities hit hard by rising costs of subprime loans."

And Krugman really believes that more regulation, more oversight, will prevent crises in the future? Well, I suppose that when you're delusional enough to blame the "free market" for what it didn't do, you're delusional enough to believe the Fed and government will "rescue" us from the financial monster they created.