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Krugman's Misreading of US Banking History

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.

  • MichaelM

    You know what I think is sad?

    Krugman will never read this blog post.

    He'll never have his hilariously incorrect understanding of the history of banking this country corrected.

    Comments are closed on his blog post (which is mildly frustrating considering it was posted yesterday), so there's not even the opportunity to correct his false narrative for his readers.

    It's a shame that somebody who so confidently and, from the point of the amateurs who read him, expertly spreads falsehoods has such a privileged position in the media establishment. There are a great many people who get ALL their economic analysis from Krugman and ONLY Krugman and just never bother to question or read into things on their own.

    This is such basic stuff. A casual reading of banking history in the United States would show you that government has been involved in banking here since there was a United States. There never was a time that government was not involved in banking. And yet Krugman tells himself (I supposed) and everybody who takes his word as holy writ that the 19th century was free market banking and it failed so now we need regulation, and that's it. Nobody tries, nobody bothers, and the body politic is made worse off for the failure.

  • Jimbo

    What were the reasons for the prohibitions on interstate banking?

  • “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.” – Paul Krugman

    Upon further review, the statement “In the 1930s, after the mother of all banking panics…” yields the following:

    (1) Krugman labels a particular episode as the biggest and worst,

    (2) Krugman, in his zeal to make a notional point by rewriting history, inadvertently points out government failure of the biggest and worst,

    (3) Krugman, by selectively reconstructing history to fit his notional argument, exposes massive government regulatory failure [Friedman and Schwartz, The Great Contraction 1929-1933].

    Krugman merely advocates government failure to fix government failure . -Or- “Government is the only enterprise on earth that when it fails, it merely does the same thing over again, just bigger” – Don Luskin, TrendMacro

  • Bill Stepp

    I'm shocked that Krugman misreads US banking history. Shocked I tell you.
    Another nail in the coffin of the fable that Gilded Age America was a land of laissez-faire was driven by historian Richard White in his book Railroaded: The Transcontinentals and the Making of Modern America (Norton 2011). He discusses bank involvment in railroad finance, and the subsidies that helped build the railroads.

    At the beginning of a section on the Interstate Commerce Commission, he writes:

    In the late 1880s the battle between antimonopolists, who sought to control and regulate the railroads, and railroad managers, who sought to lessen killing competition, resulted in a fragile truce whose fruit was the Interstate Commerce Commission (p. 355).

    As John Steele Gordon says, "This is an exciting story and well told." Highly rec'd.

  • Mike Sproul

    In addition to interstate banking restrictions and bond backing requirements, I would add that government restrictions on the ability of banks to suspend convertibility for 30-60 days was directly responsible for bank runs. As long as private banks followed the conventional practice of only issuing money (paper or checks) in exchange for securities that matured in 60 days or less, this practice would protect them against the maturity mis-matching that sometimes led to bank runs.

  • Paul Marks

    I despise Krugman – who is indeed a shameless liar (and I use the word "liar" deliberatly – he often says things he must KNOW are false, such as talking about government spending cuts in nations where there has been no such thing).

    However, this article is very odd.

    First of all the comment about "suspension of cash payments" – unless that is agreed by contract (always read the small print) then "suspension of cash payments" is CONTRACT BREAKING, and should not be allowed. Not for 30 days – not for one day.

    Still it is the article itself that bothers me.

    There were many regulations that were wrong (such as the National Banking Acts which concentrated banking in New York City), but what is this talk of banks being compelled to have government bonds to "back their currency".

    I AGREE that banks should not have been compelled to have government bonds – but what is this "their own currency" stuff?

    Banks claimed to be lending out DOLLARS (from real savings) NOT "their own currency".

    If the banks had said they were lending out (for example) "Pongos" freshly printed in their back office – then I would have no problem.

    People could choose whether to accept "the Pongo" as money (i.e. as a medium of exchange and store of value – to use to buy goods and services and to make savings in) or not.

    Someone could say "no I do not want to be paid in bank Pongos I want to be paid in Dollars" – or say that there were happy to be paid in Pongos (printed at some bank).

    But, I repeat, the banks claimed to be lending out DOLLARS.

    The banks either had these Dollars they clamied they had – or they were committing FRAUD.

    At least "fraud" as an ordinary person would understand the word (i.e. people pretending to have, indeed to lend out, stuff they did NOT have).

    The problem with government regulations was not that they "restricted" this – it was that they ENCOURAGED it (as long as banks played the "government bonds" game).

    Either a money lender is honest (i.e. lending their own or their clients REAL SAVINGS) or they are crooks – lending out "money" they DO NOT REALLY HAVE (i.e. DOES NOT REALLY EXIST).

    Basic economics – if there is credit-money expansion (i.e. the lending out of money that DOES NOT REALLY EXIST) there there will be a phony "boom" and then a BUST.

    I am astonished at the lack of understanding there is of this basic point.

    "But Paul libertarians believe in private currencies".

    This was NOT a matter of private currencies.

    The banks (I repeat) did not claim to be lending out "Pongos" (or whatever) they claimed to be lending out DOLLARS (not a private currency).

    Of course there was a bust every few years – because if you have credit money expansion (a "boom") there must be a bust.

    Borrowing (either from investment or for consumption) either comes from REAL SAVINGS or it comes from credit money expansion – and if it comes from credit money expansion you will have a "boom" and then a BUST.

    This is a really basic point – but it keeps being overlooked.

  • MichaelM

    Paul, why does every single response-thread here require a retread of the 100% reserves issue?

  • Paul Marks

    Errr Michael it was not me who falsely implied that the banks were lending out private currency – I repeat they claimed to be lending out DOLLARS.

    Nor was it me who falsely implied that there would be no boom-bust events if banks were not "restricted" by regulations. The banks themselves might be less likely to go bankrupt (bankruptcy of banks was indeed far less common in, for example, Canada) but the boom-bust events would still occur – IF lending was made from credit-money expansion (not real savings).

    Please Micheal look at the wider world – what discredits "capitalism" more than anything else (in the eyes of the population) BUSTS.

    What causes the bust? The BOOM (the credit-money boom) causes the bust. Want to prevent busts, then you must prevent the "boom".

    Otherwise PAUL KRUGMAN WINS – "capitalism" is discredited and even greater collectivism has the support of the public.

    None of this is a new discovery.

    That credit expansion (i.e. lending out money that DOES NOT REALLY EXIST) causes a boom-bust event (and, another point which is used to bash us over the head, vastly increases INEQUALITY – even after the boom-bust event has run its course).

    "100% reserves" is not terminolgy I used in my comment.

    I have no objection to a bank (or any other money lender) lending out 100% of the gold (or whatever other currency is being used) they have.

    Every last scrap of it.

    As long as people clearly understand that a "deposit" is nothing of the kind – i.e. that the money is NOT "deposited", it is lent out.

    In short that people who give their savings to bankers are told (openly and honestly) that they do NOT have these savings any more (and can not "draw them out") till when and IF the people the bankers lend the savings (whether gold or paper Dollars) pay the money back.

    In short that "depositing" money in a bank is an INVESTMENT – which may earn you interest, but may also cost you the money you have invested (the same as any other investment).

    One should, of course, not be able to count on "deposit insurance" – any more than one can "insure" against losing money in investing in a local shop (or whatever). One can insure against bad weather – but not (rationally) against bad business judgemnet.

    "Why does everything come back to…."


    I did not raise the issue of banking and boom-busts. I was making a COMMENT on the post of someone else.

    Also busts are the ELEPHANT IN THE ROOM.

    It is not simply a historical matter – for example the failure of SUPPOSED "free banking" in Chile in the 19th century (which associates, in the minds of mnay people in Chile, the free market with extreme inequality and boom–bust events).

    It is a matter of NOW and the FUTURE.

    If we (free market supporters) do not come up with an explination of busts (and how to prevent them) then the collectivists will.

    And their policy will not be that lending should be from REAL SAVINGS (rather than credit-money book keeping tricks).

    Their policy will be de facto goverment control of the financial system.

    They are already getting there – banks (right now) are dependent on government (including Central Banks).

    They (in various complex ways) borrow (newly created – from NOTHING) money from Central Banks (such as the Federal Reserve and the European Central Bank) and then (also in various complex ways) they lend this money (money created from NOTHING) BACK TO THE GOVERNMENT.

    And the banks live (or try to live) off the difference between what they pay for the money (the money created from NOTHING) and the interest (and so on) that the governments pay them when they lend the money back to governments.

    That system can not be defended – and of course Free Banking people do NOT defend it.

    But how did we get here?

    Why is that a forbidden question Michael – why I am an evil man for mentioning the problem when someone writes a post on BANKING (it is not as if I had gate crashed a website on stamp collecting or something).

    For example, Anglo Irish bank (the biggest bank in Ireland) was not undermined by special government regulations.

    It was undermined by its own credit bubble antics – lending out "money" that it did not have (indeed that never really EXISTED).

    When such enterprises fall apart (as they are in Spain, and so on, RIGHT NOW). What are we to say?

    "Well if there was deregulation this would not have happened".

    After the laughter has died away, people will turn away from us. And towards the collectivists.


    Yes that would have created terrible suffereing in Ireland (had they allowed the Irish banks to go bankrupt), just it would in Spain (if the government there let the banks go) – but, in the end, less suffereing than will happen anyway.

    Let us be HONEST – is that so hard?

    Lending out stuff you DO NOT HAVE (stuff that DOES NOT EXIST) is not the road to prosperity.

    There is only one road to prosperity – thrift, hard work and self denial.

    You can not have your cake and eat it as well.

    Money for lending can not (with good long term results) be created by the government printing press OR private book keeping tricks.

    When the economy comes down in 2013 (all over the world) do you really want to stand up and say…..

    "The credit bubble would have worked – if only there had been some deregulation".

    Is that the platform you want to stand on?

    The credit bubble will NOT work – regulation or deregulation (whatever) it will NOT work.

    Want money to lend out?

    Then SAVE money (i.e. do not consume all your income).

    You can not (with good long term results) get money to lend by book-keeping tricks.

    Only by REAL SAVINGS – your own, or the savings that other people have decided to risk by entrusting them to you.

  • Paul Marks

    To put it really short….

    The same money can not be in two different places at the same time. If it is lent out it can not (at the same time) still be in the bank.

    Nor is a practice (by various complex interactions between banks) of lending out 1000 Dollars for every 100 Dollars that actually exists a practice of "10% reserves".

    It is not 90% of the money that has been lent out – it is 1000% of the money

    Not nine tenths – but one hundred tenths.

    And, sorry, that sort of thing is not going work very well over the long term.

    This is the long term – Lord Keynes is dead, but we are not.

    Stop pretending that if this or that statute was repealed the scam would work (although – repeal the statutes, I AGREE).

    The scam would not work (apart from for the scam artists themselves).

    It will not work because it is a scam.

    And you can not build the foundations of an economy (of hundreds of millions of people) on smoke and mirrors – on book keeping tricks.

    Why do I keep banging on about it?

    Because it does not seem to be sinking it.

    The faith in the perpertual motion machine (in lending without saving – without real SACRIFICE) remains.