Mises Daily Articles
Sticking to the Official Narrative
In a politicized society, it seems to me that the true believers really don't have conversations as much as they deliver monologues of talking points. For example, a colleague of mine recently told me that "global warming" has become such a crisis that "new hurricanes are being created every 13 seconds." This would mean that more than a million hurricanes appear in the Atlantic every year — a claim that is preposterous on its face — but this does not seem to faze her. Her political party has told her that "global warming" is a catastrophe, and that is good enough for her.
One of the characteristics of people who perpetuate political talking points is their inability to be "confused with facts." In such a society, one sticks to the narrative no matter what. So it is with Paul Krugman.
There is real irony in what Krugman writes concerning so-called financial deregulation. In a recent New York Times column, Krugman declares,
When I first began writing for The Times, I was naïve about many things. But my biggest misconception was this: I actually believed that influential people could be moved by evidence, that they would change their views if events completely refuted their beliefs.
If there is anything that characterizes Paul Krugman, it is his constant devotion to following his chosen narrative — that Ronald Reagan and his gang of free marketeers turned the US financial sector into a free-market experiment with disastrous results. Furthermore, in his narrative, government regulation (when a Democratic administration is in office) is always wise, all knowing, and locked in battle against irresponsible free enterprise. Krugman has demonstrated himself to be incapable of grasping any other viewpoint, even when the historical evidence has refuted him.
So it is with his latest column. I will let Krugman's own words speak for him:
Let's recall how we got into our current mess.
America emerged from the Great Depression with a tightly regulated banking system. The regulations worked: the nation was spared major financial crises for almost four decades after World War II.…
The first big wave of deregulation took place under Ronald Reagan — and quickly led to disaster, in the form of the savings-and-loan crisis of the 1980s. Taxpayers ended up paying more than 2 percent of G.D.P., the equivalent of around $300 billion today, to clean up the mess.
But the proponents of deregulation were undaunted, and in the decade leading up to the current crisis, politicians in both parties bought into the notion that New Deal-era restrictions on bankers were nothing but pointless red tape. In a memorable 2003 incident, top bank regulators staged a photo-op in which they used garden shears and a chainsaw to cut up stacks of paper representing regulations.
Well, not exactly. It seems that Krugman has tried to stuff a few facts down the memory hole. History and Paul Krugman might not be allies here.
For instance, the first real, sweeping legislation toward banking and financial "deregulation" was the Depository Institutions Deregulation and Monetary Control Act (DIDMCA), which was passed by a Congress dominated by the Democratic Party and signed by President Jimmy Carter in 1980. Now, unless I am mistaken, Carter and the Democrats of that time were not exactly ideological Reaganites, but none of that matters to Krugman and his followers. The idea is that if they repeat the mantra enough times, it will come true.
The DIDMCA legislation did not occur in a vacuum, and it certainly was not created in an ideological frenzy. In the late 1970s, the United States was suffering from serious stagflation, with unemployment rates rising to their highest levels since the Great Depression, and inflation soaring in the double digits.
To make matters worse, interest rates were rising (the prime rate ultimately reached 21.5 percent in 1982) and banks and savings-and-loans institutions were constrained from allowing market rates on their savings accounts by Regulation Q. (Interestingly, the New York Times itself editorialized in favor of eliminating Regulation Q, and it was the Democrats that did away with it, not conservative Republicans or Ronald Reagan.)
The push to eliminate interest-rate ceilings was not borne of conservative ideology, no matter what Krugman might claim. Instead, savings and loan institutions (S&Ls) found themselves rapidly losing reserves, and people pulled their money from the low-interest accounts and put them into money-market accounts. To make matters worse, a number of S&Ls had mortgages being paid back at interest rates of 5 and 6 percent, which meant they were losing money.
Thus, it should not be surprising that banks and S&Ls were facing some real crises, and Congress sought to address those problems. (Whether or not DIDMCA was the best way to deal with the issues is up for debate.)
Second, many of the early advocates for deregulation came from the so-called "liberal" side of the Democratic Party. Ted Kennedy sponsored airline deregulation in 1978, and Alfred Kahn, Jimmy Carter's economic advisor and his "Inflation Czar," was the architect for many of the deregulation initiatives. In fact, Ronald Reagan received an endorsement from the Teamsters union in 1980 after he agreed to delay trucking deregulation for two years.
The small, highly regulated banking sector that Krugman praises was clearly not able to handle the numerous new investments in high technology and telecommunications that came about during the 1980s. In fact, for many of these innovations, from Ted Turner's Cable News Network, founded in 1980, to the advent of modern cell phones via McCaw Cellular, the main financial engine was Michael Milken and his "junk bond" empire at Drexel Burnham Lambert. Milken also was behind the financing of many leveraged buyouts and mergers that shook up the complacent US firms, which were clearly falling behind in global business.
Contrary to what Krugman or others might think, Milken was not a product of financial deregulation; he operated outside the banking sector. Furthermore, his investments were not "protected" by the moral hazard of deposit insurance or any implicit guarantee that the Federal Reserve System would "bail out" Drexel if it made bad economic choices.
What Drexel did not have, however, was the political backing to survive. Regarding the opposition to Drexel, Jeff Scott said,
In general, established business interests do not like innovations that undermine their competitive position. It is well documented that the exaggerated charges against junk bond-financed takeovers had a basis in self-serving motives. One can only grimace in disbelief at the inconsistencies of top U.S. companies who rationalize mergers when big buys small but inveigh against LBOs (small buying big).1
Murray N. Rothbard also spoke out against the opposition to Milken and Drexel:
What Milken did was to resurrect and make flourish the takeover bid concept through the issue of high-yield bonds (the "leveraged buy-out").
The new takeover process enraged the Rockefeller-type corporate elite, and enriched both Mr. Milken and his employers, who had the sound business sense to hire Milken on commission, and to keep the commission going despite the wrath of the establishment. In the process, Drexel Burnham grew from a small, third-tier investment firm to one of the giants of Wall Street.…
The big banks who were tied in with the existing, inefficient corporate elites, found that the upstart takeover groups could make an end run around the banks by floating high-yield bonds on the open market.
I bring out the Milken situation because the so-called ideological "deregulators" that Krugman claims turned Wall Street into a chaotic, "free-market" free-for-all actually supported action against Milken. The notion that David Rockefeller is an apostle for free markets might play well in the New York Times, but it does not square with the facts.
The other point is that the "deregulation" of the savings and loan system in particular and financial services in general expanded the moral hazard that is built into a fractional-reserve system. For all of the talk that the banking system needs to be re-regulated, one cannot have a wide-open financial system and a government backstop that keeps financial institutions from experiencing the full force of bad investment decisions.
Despite Krugman's rewriting of history, there is no doubt that the banking and financial systems in 1980 were in trouble. Ironically, by turning on Milken, the government actually increased the moral hazard within the system. The reason I make this point is because Milken did not operate with government financial guarantees. If the system he developed succeeded, then he and others associated with him profited; if it failed, they and those that invested with them bore the costs, but the costs could be contained within the economy.
Once the government made it clear that the success of Drexel and Milken would not be tolerated (Rudy Giuliani used his unjustified prosecution of Milken and others on Wall Street to jump-start his political career), that made it even easier for the government-protected banking system to gain political favors. They had used the state to destroy the competition, but by encouraging expansion of the subsidized financial backstop, the banking sector also set the stage for its own set of major crises.
Certainly, the S&L meltdown of 1989–1990 (which occurred in part because tax "reform" in 1986 affected the value of real estate, the asset that dominated S&L portfolios) was a precursor. But instead of trying to deal directly with the cause of the problem, Congress and the Federal Reserve created a system in which the government took over "troubled" assets from failed S&Ls and sold them to the general public.
To make matters worse, after Alan Greenspan became chairman of the Fed in 1987, the government's policy of creating and expanding moral hazard became even more pronounced. First, after the stock-market crash of October 1987 (caused, as financial economist Mark Mitchell noted 20 years ago, by unwise legislation being pushed through Congress), Greenspan vowed that the Fed stood by to "provide liquidity" to the financial system. Thus, the infamous "Greenspan Put" was born.
Second, Greenspan used his influence to recklessly expand not only the nation's monetary base but also the power of the Fed. The recession of 2001, coming in the wake of the collapse of the Fed-produced stock-market bubble, should have been a dire warning, but Greenspan managed (in the words of Peter Schiff) to "seamlessly move from one bubble to another."
Taking cues from Greenspan and Bernanke, the financial system not only had some of the regulatory handcuffs removed but also pursued "opportunities" they never would have gone after had there not been the wink and a nod from the Fed. Ironically, the most free-market financial titan had been Milken himself, and it is no accident that many of the companies he financed would become major leaders in the development of high technology. Perhaps it is not at all ironic that the Wall Street barons and the political classes would unite to stop the free market.
None of this will make it into Krugman's narrative. His response to our financial history of the past 30 years reminds me of detective Hercule Poirot in Murder on the Orient Express. After having examined all of the evidence in the murder and being faced with an obvious conclusion, Poirot decides to pursue an alternate (and untrue) explanation, mostly to protect the killers.
There is sound economic theory and evidence that clearly explains what has happened in the US financial system these past three decades. But Krugman pursues the easier (and less-believable) account: ideological free marketeers recklessly permitted other ideological free marketeers on Wall Street to pursue their ideological investments, all of which came crashing down. Instead of providing even a cursory reading of the actual financial situation in 1980, Krugman creates his own politicized narrative.
Now, if a politician or an English professor were to be providing this account, that would be one thing. I expect politicians to be dishonest and self-serving, and I expect English professors to be ideological leftists incapable of coherent economic thought. But when an economist — and one as decorated as Krugman — says these things, my mood turns much darker. There is a reason for him to pursue this false narrative, and it is not because he actually believes it.
- 1. Scott, Jeff. 2002. "The Rise and Fall of Drexel Burnham Lambert: A Ten-Year Retrospective." Unpublished Manuscript. Originally presented at the Austrian Scholars Conference (2000).