Krugman's Misreading of US Banking History

Steven Horwitz

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.

Comments

[R2g2]

Canadian banks didn't fail or need huge bailouts in 2008 either, but this time round finance was much _more_ regulated in Canada than in the US. Maybe it's just something about the air over there.

[Daniel Kuehn]

Two honest questions from an underinformed commenter, and one comment:

1. So did state chartered banks not fail at the same rate as national banks in the earlier panics? If the bond collateral requirements were the issue, that's what you'd expect. As a Keynesian, Krugman should have no trouble whatsoever accepting that bond collateral requirements are just as much a barbarous relic as the gold standard (the gold standard also being a "government regulation", of course).

2. On the Canada comparison, it seems to me that if you're comparing a branching system to a non-branching system what you'd want to look at are establishment failures, not firm failures. If Canada's banks branched certainly you'd expect less failure of the banks themselves. Does that mean that less actual establishments closed? Or more importantly, does that mean that the money supply constricted less during these panics?

And a comment:

Canada went off the gold standard in 1929, no? That seems very relevant to the story of how they fared in the Great Depression - arguably more relevant than the other regulations.

[Daniel Kuehn]

Oh - and I can't help but point out - the bond collateral requirements of course would not be so onerous if the federal government were doing its job w.r.t. fiscal policy. This is largely the point of fiscal policy now: to make that particular investment vehicle plentiful.

[Steve Horwitz]

Daniel,

1. The comparison isn't pure because the state-chartered banks faced a 10% tax on their issues of banknotes, imposed by the Civil War Congress when the realized no one would take a federal charter (and thereby buy up the bonds to fund the war) unless there was a reason. State-chartered banks were also subject to similar bond-collateral requirements, and in some cases those were railroad and other private sector bonds.

I don't know if the failure rates were higher, but the important point is that the state-chartered banks were subject to many of the same regulations plus the tax on note issue, so it's not clear what any difference would show.

2. Yes, Canadian offices closed, though not nearly to the extent that US banks failed. But so what? If you hold a bank liability, there's a huge difference between the inconvenience of having to do your banking in the next town (or at a different branch in the city) and your bank being insolvent and unable to fully pay what it owes. That difference is exactly the reason to prefer branched systems.

[Daniel Kuehn]

re: "But so what"

Right - I agree. That's why I added the point about the money supply, which is the real issue. Bernanke would argue that there is critical local knowledge lost when offices close, but presumably the money supply is the more critical point, not the bank failures themselves.

[Daniel Kuehn]

Oh I meant to link to this too on the money supply: http://www.jstor.org/discover/10.2307/1828909?uid=3739936&uid=2129&uid=2&uid=70&uid=4&uid=3739256&sid=47699001417527

It looks like it did not drop as precipitously as in the U.S. (although the hit to GDP in Canada was still substantial). But then, that makes me wonder whether this is a function of banking regulation or the fact that they left the gold standard.

[Josh S]

Don't forget the backing of railroad bonds by the government, leading to the same sort of moral hazard scenario that resulted in the Panic of 1893.

I suspect--and this is being charitable--that Krugman looks at "regulation" the same way he looks at "spending." All that matters is the size of the aggregate, and he really can't be bothered with what the details are. He doesn't seem to believe that details matter, or at least that small, structural details are largely irrelevant to large-scale phenomena. So when he looks at the two eras, all he sees is the difference in the quantity of regulations. Therefore, 19th C panics were caused by "low regulation," and the only way to stop financial crises is with "high regulation." He's self-blinded to what the individual regulations are, because it's not something that he thinks matters.

The idea that ten pages of really bad, deeply structural regulations can destabilize a banking system as badly or worse than a thousand pages of trivial regulations isn't really in his intellectual toolbox.

[Steve Horwitz]

Yes, Canada was not hit by the GD in quite the same way as the US, mostly because they avoided both the awful monetary policy as well as the bad labor market policies. They had trouble in agriculture, but even there it didn't translate into a collapse of the banking system the way it did here.

[John V]

As I said on FB yesterday, PK smugly scoffed at the idea of TV debates on econ because it's so easy to spew nonsense and play loose with narratives with no real room for deeper counterarguments and clarity. But when given an op-ed article to make a larger case for a national audience, he does just that.

I am no expert on this stuff but having read various articles in the past from the likes of Robert Higgs and others about the specific anatomies of the 19th Century/Early 20th Panics, PK's quick, self-serving account of those Panics struck me as unbecoming of a PhD in economics as soon as I read it. It reads more like material from a college freshman with a bone to pick or an activist journalist who doesn't know up from down.

He may be no expert in economic history but he's still an economist and should know better about these things regardless of his area of expertise. And it obviously wasn't a question of time or space constraints since you managed to shed some light on the matter within a few sentences. Shame on PK and those who rationalize or defend him on this. (Cough, DK, Cough)

[Daniel Kuehn]

I'm not sure you need to go around shaming people, John V. I was just asking a few questions that came to mind after reading this informative post. You realize that one can simultaneously entertain questions about both Steve's case and Krugman's case, don't you?

[Josh McCabe]

FWIW The United States has what is probably the most highly regulated financial sector in the world. Europe does not even come close in terms of regulation. Check out:
James R. Barth, Gerard Caprio Jr., and Ross Levine, The Regulation and Supervision of Banks Around the World: A New Database, The World Bank Development Research Group Policy Research Working Paper 2588 (2001)

I also highly recommend Monica Prasad's work on the Credit/Welfare State Tradeoff to help explain why the "liberal" US has so much bank regulation.

[John V]

You're right, DK. I don't need to go around shaming people. I apologize. But that WAS in jest. Let's just keep that in mind.

Nonetheless, this should all be pretty basic stuff in economics circles. The way I see it is that if I (of all people) had some prior understanding of all this even before reading Steve's post then I would think people who make a career in this field have no excuse in being so sloppy (at best) or disingenuous (at worst) with this material. In that sense, it IS somewhat shameful of PK. Let's be honest.

And if I am giving him too much credit in assuming he knows exactly what Steve is talking about then that doesn't speak very highly of such a talented mainstream economist's ability to properly understand the anatomy of critical economic events that he seems to be speaking so authoritatively on.

Yes, economists can quibble over details BUT to ignore the regulatory framework's role in the Panics he's using as examples to underpin arguments about why we need more regulation is simply inexcusable. As usual, I find the typical Keynesian woefully ignorant (or dismissive) of perverse realities wrought by regulation and the political economy and public choice theory that makes the creation and enactment of such laws and regulations anything but the simple, straightforward, sterile and benign endeavors that these Keynesians seem to think they are.

No true appreciation of the messiness and the potential corruption and gross error in such acts can possibly lead these economists to such simplistic thinking about problems and solutions. I can only they flat out don't care or don't get it. I am not wrong in these views. And I don't need a PhD in economics to know better about this general concept. That such concepts would be absent amid all the accumulated knowledge of many economists in akin to a state of the art 2012 Ferrari equipped with a cheap suspension design from a 1970 Fiat 500. Just as inexcusable.

[Daniel Kuehn]

re: "The way I see it is that if I (of all people) had some prior understanding of all this even before reading Steve's post then I would think people who make a career in this field have no excuse in being so sloppy (at best) or disingenuous (at worst) with this material. In that sense, it IS somewhat shameful of PK. Let's be honest."

Earlier I was more interested in discussing the issues than Krugman, but it's worth sharing a brief thought on him. I think you are confusing a claim about little regulation with a claim that there was no regulation. Of course banks weren't entirely unregulated back then. I never took Krugman to be saying that. Reasonable people can argue about how significant the regulations that were in place are - Steve's made his case on that. But reasonable people can disagree, and as far as I can tell Krugman has stayed within the realm of reasonableness on this.

And needless to say, I can't take the premise that Keynesians consider regulation "simple, straightforward, sterile, and benign endeavors" seriously at all. I know this is the line you always fall back on, but I've never seen it.

But at least we can agree with each other that such a perspective would be problematic.

[McKinney]

As Hayek said of Keynes, Krugman knows very little about economic history and less of banking history. But that never stopped Keynes from talking endlessly about it and it won't stop Krugman, either. Most of his audience is ignorant about all history, so they won't have a clue as to how ignorant Krugman is about banking history.

[Bill Stepp]

Krugman writes:

But banks are special, because the risks they take are borne, in large part, by taxpayers and the economy as a whole. And what JPMorgan has just demonstrated is that even supposedly smart bankers must be sharply limited in the kinds of risk they’re allowed to take on.

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.
____

Far from staying "within the realm of reasonableness on this," he's completely wrong on both claims. In a free market banks would not be "special" (where's the Church Lady when we need her?), because their risk profiles would not be extended by (non-existent) subsidies.
Gilded Age America did not have minimal government. The various bank panics (1857, 1877, 1893, etc.) were caused by government intervention. Richard White wrote a fine book on the railroads, Railroaded: The Transcontinentals and the Making of Modern America (Norton, 2011) in which he discusses subsidies and other interventions in the building of the railroads, as well as bank finance.

[Troy Camplin]

Krugman is every person Socrates ever came into contact with, assuming he knows everything about everything because he's an expert, when he doesn't even know much about what he's an expert in. If knowing one is ignorant is wisdom, who is less unwise than Krugman?

[McKinney]

Krugman should be aware of the papers and books that show the pre-Fed era being more stable than the post-Fed, such as the works of Selgin on the history of the Fed and this paper from the Bank of England: “Reform of the International Monetary and Financial System”. Here’s an excerpt from the latter:

“Table A below, which presents a range of summary statistics on the performance of different IMFS regimes, shows for example that the incidence rate of banking and currency crises in the Gold Standard was much lower than in today’s system….

“Overall, the Gold Standard appeared to perform reasonably well against its financial stability and allocative efficiency objectives, while the internal balance objective was of secondary importance. But the effective sacrifice of this latter objective was the undoing of the Gold Standard, as growing recognition of the need to pursue domestic policy objectives (most notably, to respond to rising unemployment) and achieve internal balance eventually undermined the credibility of the restored Gold Standard in the interwar period.

“Against a range of metrics, today’s system has performed poorly, at least relative to the BWS. Table A shows that the current system has coexisted, on average, with: slower, more volatile, global growth; more frequent economic downturns; higher inflation and inflation volatility; larger current account imbalances; and more frequent banking crises, currency crises and external defaults.”

[Greg Ransom]

Anybody read Bruce Bartlett's hit piece on Austrian economics in the NY Times today?

[Jule Herbert]

I saw it.

http://economix.blogs.nytimes.com/2012/05/15/what-rule-should-the-fed-follow/?ref=brucebartlett

I think this has always been Bruce's view -- even as a supply-sider, he was an anti-Austrian monetarist.

But he is smart enough to know he is using the terms of "inflation" and "deflation" to equivocate (mislead) what the Austrian view of the 1920s was.

[Nikolaj]

Steve Horwitz:

"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."

So, the problem was that the government did not allow the banks to inflate enough? The catch was not that the banks overinflated during the boom, but that they were sabotaged by government regulations in inflating even more during the bust? I always know I am in the company of a good "free market" Keynesian whenever a theorist finds it necessary to invoke the bogey of "currency shortages" and evil government checks to inflation, in order to explain the bank panics and financial crises.

Btw, the Canadian chartered banks had also to hold a large amount of government bonds as a reserve, and yet, they did not seem to experience the same kind of panic episodes as the American banks.

[Lee Waaks]

Accusing Steve Horwitz of being "pro-inflation" or "Keynesian" is like accusing a person of being a child molester just because he like to work with children.

[Mario Rizzo]

There is a "market failure" here. Krugman gets the Nobel prize for very good, though not great, work on international trade. And then the New York Times thinks that means he has the knowledge to write on all topics of public policy,politics,economic history,economic theory for the lay audience. The man has risen to the level of his incompetence thus creating a large use of resources trying to make sure that he errors don't infect the world. Perhaps Pete Leeson knows of some spell we might cast upon the man.

[Jim Rose]

The likelihood of panics depends on the industrial organization of the banking system. Banking systems with well-diversified big banks are less prone to bank runs.

The wiki on the panic of 1907 does not mention steve's paper but does mention Miron's 1986 paper on seasonality and banking.

but at http://eh.net/encyclopedia/article/wicker.banking.panics.us Elmus Wicker says that the structural weaknesses of the National Banking Act have been widely perceived as the fundamental cause of the panics of the national banking era. An inelastic currency supply, the pyramiding of reserves and fixed reserve requirements.

[Steve Horwitz]

Lee:

Don't worry. If I thought he actually understood what I'm talking about it would bother me more when he says things like that. He leads with his ignorance, both theoretical and historical, and that's all any knowledgeable person needs to see.

[McKinney]

Mario, I know that was tongue in cheek, but it is less a market failure if you keep Krugman's politics in mind. He won the Nobel and his job at the NYT because he carried water for the left by continually attacking Bush.

[BigEd]

Mr. Horwitz;

You are more qualified to expound on financial & banking history & policy than PK??

How many Nobel prizes do you have? - - - and where did you get your PhD??

BTW: Canada went off the gold standard domestically in Jan. 1929 and for international settlements in late 1931. Those are probably more likely reasons Canadian banks stayed relatively healthy during the 30's.

[Nikolaj]

"Canada went off the gold standard domestically in Jan. 1929 and for international settlements in late 1931. Those are probably more likely reasons Canadian banks stayed relatively healthy during the 30's."

What about the period 1800-1929?

Lee,
when somebody says the main cause of the 19 th century recessions was that the banks were too constrained by government regulation in expanding their credit supply I call that "inflationism". And I think it's not inappropriate to call such a person a "free market" Keynesian as I did (not a "Keynesian" as you insinuated). Of course you can find many other, fancier names for the same ideas, such as "advocating the elastic supply of money", but that's just playing the word games.

[Jonathan M.F. Catalán]

How is it appropriate to call that person a "free market Keynesian?"

[Inspector Fu]

"How many Nobel prizes do you have? - - - and where did you get your PhD??"

argumentum ad verecundiam.

[Niko]

@Catalan:

There used to be a big effort to bring Austrianism and Keynesianism and neoclassicism together. The "free market keynesian" is an adequate description of this effort.

[Niko]

@Inspector Fu:

You should also be as prompt when Professor Horwitz asks for your CV (he has an obsession with peer-reviewed articles) when you challenge his ideas.

[Jonathan M.F. Catalán]

Niko,

What does that have anything to do with anything (and what big effort are you referring to? Lachmann's?). Monetary equilibrium theory is not "Keynesian," since it predates Keynes, was developed by non-Keynesians, and Keynes' own theory was not a monetary equilibrium one.

[Jerry O'Driscoll]

Catalan is correct about monetary equilibrirum theory. It is a precursor of monetarism, not modern Keynesianism.

We have come a long way from Horwitz's original post. I note that typically happens when DK is an early responder. Things just go off track.

[Josh S]

Back on topic, what incentive does Krugman have to get his history right? His customers are largely completely ignorant about economic theory and history, and they're not going to read anything more academic than an op-ed, so he's not going to be punished by the market for being either lazy or dishonest.

Furthermore, the "job" he's been "hired" by his customers to do is use his authority as a professor and Nobel Memorial Prize winner to excoriate the right in all its forms and factions, from the libertarians to the neocons to the socons to the fiscally conscious moderates, to give intellectual cover to political hatreds. He's doing his job if he's condemning the right and elevating the left; diligence regarding history and representing others' theories is really not a useful part of the partisan toolkit.

[alternative investments]

A classic case of screwed up government regulation were these limitations on banks doing business across states lines. Of course banks then looked for ways around that.

[Peter Lewin]

Maybe y'all saw this:

http://www.nybooks.com/articles/archives/2012/may/24/how-end-depression/?pagination=false&printpage=true

[Aaron Strout]

Niko,

What does that have anything to do with anything (and what big effort are you referring to? Lachmann's?)

[Mathieu Bédard]

To go back to the original post, isn't this another case of misplaced concreteness? Reality MUST fit Diamond & Dybvig's model, otherwise it's right wing mythology.

[Nikolaj]

Catalan,

not "free market Keynesian" but '"free market" Keyenesian'? Got the difference?

[Nikolaj]

Salerno on Horwitz:

http://bastiat.mises.org/2012/05/2-98-cheers-for-bob-murphy/#comment-575

[MH]

Worth reading :
http://www.cato.org/pubs/journal/cj16n1-3.html

[mwzmiki]

Make money online :

http://wall-street.uni.me/?post-aj.html


financial planning calculators steuern auf 400 euro job tsa jobs moo cards professional card tricks revealed

[mlzjiky]

Make money online :

http://finance.uni.me/?post-va.html

christopher u0026 bank acu-shield financial craigslist jobs york region apology letter sample for not calling in at work executive job search

[R Gregory]

Thinking that the Canadian system was more laissez faire is highly contestable. In fact, most Canadian banking regulation during the period in question were modeled on US regulations. see for example :http://faculty.marianopolis.edu/c.belanger/quebechistory/encyclopedia/BankinginCanada-CanadianBanks-CanadianHistory.htm

Your point about a lack of Canadian bank failures glosses over the historical record. The Canadian federal and provincial governments have always shown a willingness to preserve banks by financially backing mergers and bailouts when needed, unlike the US Government (For example in 1923, Quebec used $15 million of off balance sheet financing to finance a merger). See :http://www.jstor.org/stable/10.2307/2077768 . Canadian governments historically in the 20th century have provided an implicit 100% guarantee of all bank deposits. Plus, while it is true that no Canadian banks were allowed to "fail" by the government during the Great Depression, there were a number of branches closed.

[Karina]

There is indeed a resaon.Online transfers aren't actually online transfers (or they haven't been and won't be until this change is in place). They are to all intents and purposes essentially instructions to your bank to create a one off standing order on your behalf.You will note that the standing order instruction is processed by the recipient of funds, with instructions to get money from your account. It's not processed by the bank sending the funds.They are processed in exactly the same way by the back end. Recipient bank has to process via clearing (which takes a few days) and your bank then has to ensure you have cleared funds at that point.Basically, direct transfers in online banking were bolted onto the existing infrastructure when online banking became prevalent. There were enough problems to solve (remember RBS's original fat client system?) without creating a completely new clearing system amongst all the banks that are part of the retail clearing system.

[Ligia]

I recommend reeadrs go to the Krugman post, and write a comment, using the words Market Monetarism. The more we pound out the words market monetarism, the more recognition it will get (right now we are under threat even at Wikipedia). I think Krugman is largely referring to the Market Monetarists who else is saying anything new?

[Freddy]

At last, smooene who knows where to find the beef

[Nanae]

escrow! You read that right: the Greek bailout #2 is nhnoitg but a Greek-funded bailout of Europe's insolvent banks and the Greek constitution is about to be changed to reflect this!The smoking gun quote: The Eurogroup also welcomes Greece's intention to put in place a mechanism that allows better tracing and monitoring of the official borrowing and internally-generated funds destined to service Greece's debt by, under monitoring of the troika, paying an amount corresponding to the coming quarter's debt service directly to a segregated account of Greece's paying agent. As for the priority of payments it is more than clear: Finally, the Eurogroup in this context welcomes the intention of the Greek authorities to introduce over the next two months in the Greek legal framework a provision ensuring that priority is granted to debt servicing payments. This provision will be introduced in the Greek constitution as soon as possible. για να φτάσουν στο προφανέστατο συμπέρασμα:So there you have it: the Second Greek bailout is nhnoitg but the first Greek bailout of Europe's banks! And the Greek constitution is about to be changed to reflect that. και στο τέλος μας συγχαίρουν:Congratulations Greece you just got royally raped by your own unelected rulers and you didn't even know it.Οπότε, μην βιάζεστε να επικροτήσετε την περηφανή νίκη της Παπαδήμειου κυβέρνησης και να αιτιολογήσετε τα δίκαια αιτήματα των έντιμων δανειστών μας που δεν εμπιστεύονται τους άτιμους Έλληνες Σκεφθείτε πρώτα