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One Cheer for Paul Krugman, or Why the Bubble Economy?

January 1, 2009

Tags Booms and BustsThe FedInterventionismOther Schools of Thought

As a long-time critic of the part-time economist and full-time political partisan Paul Krugman, I would be remiss if I did not give him at least some credit for being able to point out the obvious: Bernard Madoff's Ponzi scheme really is a prototype for the modern US economy. Yes, Krugman is right, but, alas, I am also required to add that a broken clock is still more consistent at telling time than Krugman is at explaining economic phenomena.

Indeed, the US economy has gone through two destructive financial bubbles in the past decade, although the government's response to the last bubble has been to spread the damage throughout the economy to where the damage can no longer be relatively contained. The Madoff revelations are simply another blow to the reeling financial industry that not long ago was "creating" multimillionaires who had not yet made it to their fifth reunions at Harvard or Duke.

Unfortunately, while Krugman is right in seeing the effects of the financial bubbles, he confuses cause with effect, thus violating the first law that Carl Menger gives in his ground-breaking Principles of Economics:

All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary.

Like so many other economists and pundits, Krugman sees the effect and interprets it as the cause. He writes,

The financial services industry has claimed an ever-growing share of the nation's income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it's not just a matter of money: the vast riches achieved by those who managed other people's money have had a corrupting effect on our society as a whole.

Let's start with those paychecks. Last year, the average salary of employees in "securities, commodity contracts, and investments" was more than four times the average salary in the rest of the economy. Earning a million dollars was nothing special, and even incomes of $20 million or more were fairly common. The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

Translation: the financial services industry is the cause of wage stagnation elsewhere, as Wall Street has "diverted" wealth that would have gone to other workers. How did "they" manage to pull off such a scheme? "They" just did it:

Consider the hypothetical example of a money manager who leverages up his clients' money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it's almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he'll keep those bonuses.

Krugman's explanation leaves me wondering how someone could have pulled off such schemes in the first place. Simply accusing the financial services industry of pulling a con job is not enough.

(This is reminiscent of a comment I saw in the online Chattanoogan the other night. The contributor notes that the price of gasoline recently increased there from about $1.35 to $1.55, which to him was "proof" that the oil companies are "manipulating" the price of gas. However, he has no explanation of how the price of gasoline fell from about $4 a gallon to less than $1.50, or how companies with the power to "manipulate" the price of their main product would permit a 70 percent decrease in its price in the period of a few months. No doubt, this contributor is a faithful reader of Paul Krugman's column.)

Keep in mind that this is not a defense of the Wall Street bankers or the over-leveraged brokerage houses which are crumbling after the bursting of the housing bubble. Nor is it a defense of the recent bailouts they have received or anything else that they have done during the past several years. Yet, while they are not objects of my sympathy, nonetheless they are not the "cause" of the current meltdown, despite Krugman's statements.

Again, we turn to Menger's emphasis upon cause and effect. Krugman insists that the financial managers suddenly became reckless in their money management after financial deregulation, and he even has a causal explanation: free markets.

According to Krugman's many statements, ideological, free-market Republicans took over the universe and implemented financial deregulation, upsetting a perfectly working financial system that had been carefully constructed during the Great Depression.

The Saga continues: eager to thrust their discredited ideology of markets and greed upon unsuspecting investors, these greed heads then conspired to keep the wages of hard-working Americans down by subverting attempts by heroic and caring legislators to raise the minimum wage and to re-energize labor unions (and keep Americans from receiving the universal medical care that they deserve).

But that was not enough for these greedy free-marketeers. They then promoted free trade and outsourcing, which meant that hard-working Americans were thrown out of work in manufacturing industries and forced either to go on welfare or work at — horrors! — Wal-Mart, which then further abused them by holding down their pay and denying them medical insurance. The destruction of the American economy being complete, these capitalist despoilers then managed to divert all of the new wealth to themselves and their Wall Street friends, a scheme that worked, but only for a little while until it, too, collapsed under its own weight, leaving wreckage behind. Krugman writes,

Meanwhile, how much has our nation's future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

While such a scenario might be popular at the local union hall or on the pages of the Daily Kos, nonetheless it makes no logical sense. Why would anyone chase one Ponzi scheme after another when there were other avenues of investment that were not so speculative? (Krugman has not yet resorted to the "animal spirits" description of investors given by John Maynard Keynes, although no public intellectual today has gone as far as Krugman in giving credence to Keynes and his pseudoeconomic analysis.)

In answer to such an obvious question, Krugman parrots his usual line: free markets and deregulation.

Now, Krugman never explains just how free markets lead to the kind of speculation we saw on Wall Street; we are supposed to accept his explanation on faith (Krugman's version of "faith-based political economy").

The problem begins with what economists call "opportunity cost," something that tends to elude Keynesians like Krugman. For example, a textile manufacturer is excoriated for closing down his plant — which pays, say, $8 an hour — and having the work done in China where wages are much lower. This "outsourcing," according to Pat Buchanan and others, is a prime cause of the Wall Street meltdown.

Defenders of outsourcing often use the "opportunity cost" argument, noting that if companies cannot keep workers at even $8 an hour, it must mean that they have better work opportunities elsewhere. However, such an argument presupposes that government does not interfere in markets and production or force up deadweight costs. Yet the reality of the American workplace today is that government regulations force employers and entrepreneurs to bear costs for which there is no "return on investment."

For example, I remember touring a manufacturing plant 20 years ago and the plant manager telling me that nearly all of his new capitalization expenses were going toward pollution-control equipment. Given that most economic regulation is of the command-and-control variety and made to suit the whims of bureaucrats and environmentalists, it is very likely that the equipment the government required him to purchase had little positive effect on pollution abatement. For the most part, it was pure cost, a deadweight loss (in economist speak).

Start multiplying this regulatory nightmare across an economy and one starts to understand how government manages to force costs without appreciable economic benefits (except to the politically connected firms that produce the goods required by regulators). Over time, this means that an economy produces fewer and fewer goods that people want.

In another example, I have a friend who operates a small ice cream shop. She told me about the out-and-out hostility that state regulators (in this case Maryland — but it could be any state) have for small businesses like hers. Ultimately, she has to compensate by producing less and hiring fewer people. In the end, it means less production, fewer goods, and higher costs for consumers.

Buchanan and others have decried the loss of manufacturing jobs in the United States, and hold that tariffs, quotas, and other means of preventing trade between Americans and people overseas will mean more wealth is created here. However, they make a fundamental error in assuming that higher factor costs mean that more wealth is being created. In reality, high factor costs — and especially factor costs forced up by government — result in less wealth being produced. Thus, the "solutions" proposed by Buchanan, labor unions, and others, would actually make most people poorer, not richer.

Nor is it just federal regulation that stifles the markets. Take the rural and small-town areas of states such as New York, California, Oregon, Connecticut, Pennsylvania, Massachusetts, and, yes, Maryland, for example. All of these are known for being high-tax states, dominated by legislatures that are well known for their hostility to private enterprise. All of them are dominated politically by left-wing urban populations that vote for politicians who put barrier after barrier in the way of entrepreneurs, creating the huge irony of having both large cities where per capita income and housing prices are very high, yet outlying areas in which wages are much lower than the national averages and where houses are surprisingly cheap.

(I lived for six years in Cumberland, Maryland, a city that had lost more than half of its population since the 1960s, as one manufacturing plant after another closed down. Today, the major employers are the hospital system, state and federal prisons, local government, and a community college and four-year university. This is an area where an increase in the minimum wage means that some people will receive raises, while others will be put out of work. One would think that with its low-cost labor and good medical services, and scenic beauty, and recreation opportunities that it would be a place where new employers might want to locate, but think again. Maryland law stretches out to Cumberland, too. The same goes for small towns in other high-tax, high-regulatory states.)

Such a regulatory and legal regime also reduces opportunities for investment, which means even more economic stagnation. To offset stagnation, the Federal Reserve has attempted to pump new money to "stimulate" the economy. In the 1990s, new money went into the short-lived "high-tech" boom in which the computer-savvy kids of Seattle were made temporary millionaires. In this decade, it went to the infamous "housing boom."

Austrian economists have already pointed out that the boom was not sustainable, and that the boom led to an inevitable bust. However, we also need to understand that many of the domestic lines of production that in other times would have been profitable (and sustainably so) were not attractive anymore because of the many regulatory burdens government has placed upon them. Furthermore, the domestic automobile companies have such bloated and unworkable union contracts (another manifestation of government interference with US manufacturing) that it is impossible for them ever to be profitable again.

(Even so, it still makes sense to establish manufacturing plants in other countries, especially places that are emerging markets such as China and Vietnam. If it is not a crime for Japanese firms to build automobiles in the United States, why is it considered evil if Ford or General Motors builds cars in China?)

Thus, the only game in town in which the government could give an illusion of prosperity was through aggressive action by the Fed to pump up bank reserves, stimulate lending, and then watch Americans send dollars overseas for consumption goods (as Peter Schiff is fond of saying). In other words, as long as people overseas would accept American IOUs, they would send their goods to this country, but the dollar's recent slide tells us that Uncle Seller is running out of suckers.

It should not be surprising that when the Fed engineered these financial bubbles, those on the front lines in financial services would be the main beneficiaries. However, here again, Krugman misses the boat on causality. His statement that high salaries and bonuses to financial executives caused pay "inequality" in the economy is a non sequitur. The high pay and bonuses was the result of government monetary policies, which funneled new money directly to Wall Street and the banks.

Wall Street executives did not suddenly decide to enrich themselves and then change the direction of investing in order to do so. Instead, they were able to direct large sums of money for their own compensation precisely because the government was channeling gargantuan amounts of new cash into their firms. For that matter, much of the money was channeled into the purchase of now-worthless "mortgage securities," which were created by the quasi-government entities of Fannie Mae and Freddie Mac. If ever a financial crisis had "Made in Washington" stamped on it, this was it.

Krugman and others have railed about the supposed "deregulated" Wall Street, but fail to point out that the meltdowns have occurred precisely in those areas that had either explicit or implicit guarantees from the government and Federal Reserve that losses would be covered. In other words, Wall Street banks and brokerage houses took the biggest risks (and the biggest fall) in those "investments" that promised big returns if successful and (better still) the prospect of a government bailout if losses became uncontrollable.

This is not unlike a parent giving a kid a credit card with a $10,000 limit, and the kid going out immediately and maxing out. Instead of taking away the card, the parents promise to pay the 10 grand and then give the kid yet another card, thus encouraging even more irresponsible behavior. This is not an example of an "unregulated" market; rather, it is not a real market at all, since markets involve both profits and losses, something that apparently is not palatable to modern political classes.

Thus, if we want to examine the cause of the current meltdown and the larger cause of the financial bubbles, we don't look to Wall Street: we look to Pennsylvania Avenue and the other streets in Washington, DC, where regulatory agencies and Fed offices are located. Those are the places where most of the real economic decisions are made today.

Given the fact that government piles on the business costs and destroys economic opportunity, perhaps we should not be surprised that the one profitable area was financial services. General Motors might not have sold enough vehicles to turn a profit, but its financing division made money. The same goes for General Electric and other companies that have turned profits from credit cards. For the time being, people could make money in the money markets, but as the US dollar now plunges in value, even those last profitable ventures have dried up.

As government has destroyed one business opportunity after another, perhaps we should not be surprised that investment money has left domestic production and was diverted to financial markets. Investors want a return, and government agents and the political classes seem determined to destroy free markets — and the opportunities they present for economic growth.

$24 $20

"All things are subject to the law of cause and effect."

Unfortunately, the modern zeitgeist of political economy is a return to even more massive intervention, financial and industrial bailouts, and even more regulations and barriers on the supply side. The incoming administration has promised to strengthen organized labor and he has appointed people to the environmental regulatory positions who seem to be true believers that they can save humanity through destruction of economic opportunity.

Furthermore, it is certain that people like Krugman have the ear of the political classes, and why not, since they preach that government is the salvation of us all? Instead of permitting the necessary economic adjustments to be made in the wake of this unsustainable boom, the political classes — and their court economists — insist on even more government spending, more debt, and more destruction of the dollar. Thus, they will drive the economy deeper into the trough — and then prevent the recovery — all in the name of saving economic opportunity.

William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him mail. See his articles. Comment on the blog.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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