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Krugman's Misreading of US Banking History

Posted By Steve Horwitz On May 14, 2012 @ 10:25 pm In Economic History,Financial Markets,Money & Politics,The Fed & Central Banks | 9 Comments

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.


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