Regulate Inflation? I Don’t Think So!

In the past, I have said that Paul Krugman is a one-trick pony: his answer to everything is for the government to print more dollars. Indeed, in a recent article, Peter Schiff took apart Krugman’s rewriting of U.S. financial history, noting that after World War II, contra Krugman, the U.S. Government reduced expenditures. (Burton Folsom in this article notes that, contra Krugman, the post-WWII U.S. Government also cut tax rates across-the-board, which Krugman considers to be a Great Sin.)

However, I need to give Krugman more credit, for he is not really a one-trick pony, but a one-and-a-half trick pony. What do I mean? I will explain, using Krugman’s NYT April 12 column.

Writing about the high rate of bank failures in Georgia, compared to the relative stability in Texas, Krugman writes that in most cases, the high rates of foreclosures tended to be concentrated in areas with strict zoning laws. He writes:

To appreciate Georgia’s specialness, you need to realize that the housing bubble was a geographically uneven affair. Basically, prices rose sharply only where zoning restrictions and other factors limited the construction of new houses. In the rest of the country — what I once dubbed Flatland — permissive zoning and abundant land make it easy to increase the housing supply, a situation that prevented big price increases and therefore prevented a serious bubble.

Now, this would seem to be a case of the Law of Unintended Consequences rearing its head, since all good “Liberals” like Krugman are staunch supporters of strict zoning laws, but that fact seems to have escaped the Nobel Prize laureate. Instead, Krugman claims that he has found the magic bullet that tells us why Texas does not have the same kind of banking crisis that has hit Georgia:

So what’s the matter with Georgia? As I said, banks went wild, in a scene strongly reminiscent of the savings-and-loan excesses of the 1980s. High-flying bank executives aggressively expanded lending — and paid themselves lavishly — while relying heavily on “hot money” raised from outside investors rather than on their own depositors.

It was fun while it lasted. Then the music stopped.

Why didn’t the same thing happen in Texas? The most likely answer, surprisingly, is that Texas had strong consumer-protection regulation. In particular, Texas law made it difficult for homeowners to treat their homes as piggybanks, extracting cash by increasing the size of their mortgages. Georgia lacked any similar protections (and the Bush administration blocked the state’s efforts to restrict subprime lending directly). And Georgia suffered from the difference.

It is hard to examine this point in a short column, and I don’t know how much Georgia’s banking laws differ from those in Texas, although the ultimate irony to me is that George W. Bush was governor of Texas before coming to the White House, which, according to Krugman, generally makes that state to be evil. Nonetheless, I will take Krugman’s word for it that Texas has stricter banking regulations than does Georgia (although the devil always is in the details and I suspect that the differences between Georgia and Texas are more cloudy than what Krugman tells us).

Thus, Krugman, reasons, the key to financial reform is regulation:

So what’s the moral of this story? As I see it, it’s a caution against silver-bullet views of reform, the idea that cracking down on just one thing — in particular, breaking up big banks — will solve our problems. The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.

And the contrast between Texas and Georgia suggests that consumer protection is an essential element of reform. By all means, let’s limit the power of the big banks. But if we don’t also protect consumers from predatory lending, there are plenty of smaller players — both small banks and the nonbank “mortgage originators” responsible for many of the worst subprime abuses — that will step in and fill the gap.

Thus, on one side, Krugman readily support policies of inflation and having the Federal Reserve System artificially hold down interest rates. In other words, Krugman believes our government actively should push easy money.

However, on the other hand, he also wants government to determine who receives the new money through aggressive regulation. To put it another way, he wants the government simultaneously to make water flow downhill and uphill at the same time. That dog won’t hunt, people.

Krugman seems to be the last economist who does not understand the “Capture Theory of Regulation,” which was established long ago in the formal and informal economics literature. Instead, Krugman wants us to believe that as long as the regulatory offices are filled with “smart and well-meaning” apostles of financial regulation, then everything will be fine.

To put it another way, he believes that the same government (or at least government run by experts like him) that turns on the inflation spigots also is so wise that it can tell us exactly where that inflation should be direction, thus bringing happiness and prosperity to all. I don’t think so.

All this reminds me of some parents in Chattanooga who rented a racetrack for their children to have a wild party after graduation. Their justification was that the kids were going to be drinking, anyway, so at least they could “regulate” the fallout from the party.

So, while their kids were getting stinkin’ drunk, the parents patted themselves on the back for keeping their children from driving afterward. Likewise, Krugman believes that the government should supply Wall Street with endless amounts of financial “liquor,” but that the regulators will keep everyone from getting drunk.

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