Krugman on Banks and Romney

May 23, 2012

by Chidem Kurdas

Regulation advocates seem to regard the JP Morgan loss as the best thing since sliced bread. Thus Paul Krugman gleefully bawls out Mitt Romney for refusing to see it as a sign for greater government intervention.

Krugman repeats the by now well-known argument on banks, as a riff on “It’s a Wonderful Life.” The Jimmy Stewart character makes “a risky bet on some complex financial instrument,” loses the money and causes his bank to collapse. The moral: banks should not be allowed to take on much risk because “they put the whole economy in jeopardy” and “shouldn’t be allowed to run wild, since they are in effect gambling with taxpayers’ money.”

The fact is, banks make money by taking risk. That’s always been the business model. Even Bailey Building and Loan in “It’s a Wonderful Life” makes risky home loans—one might think of them as subprime. Traditional banks are entities that take deposits, invest the money and profit from the difference between what they pay depositors and what they make on investments. In the past the investments took the form of direct loans but banks can invest in a variety of ways.

Now and then something goes wrong. When there is a major market dislocation such as a property bust, borrowers default, leaving some banks insolvent. So, since 2007 more than 440 commercial banks have failed, according to the Federal Deposit Insurance Corp.

But the argument for greater regulation is not about these commercial banks. They have long been so heavily regulated that any more regulation would in effect turn them into government agencies. Obviously the multi-layered regulatory regime has not stopped banks from making bad investments and failing. Whether this is a loan to the local developer or a play on mortgage-backed securities makes no difference for the resulting insolvency. The notion that a “complex financial instrument” must be to blame is a red herring. Banks went under in droves in past financial crises before complex instruments were even invented.

In any case, the idea is that big banks’  risk taking should be overseen more tightly on the ground that they might damage the economy. Government bureaucracies are already deciding how much risk is allowed and what is excessive; the argument is for further expanding their remit.

Sure, banks make mistakes, but does anyone honestly believe government bureaucrats know better? They’ve never shown any evidence they understand the supposedly simpler risks small banks take. It is logically incoherent  to suppose they understand the risks of big banks. If the Federal Reserve had any notion of the risks banks – big or small – were taking, it should not have allowed credit to grow so much in the early 2000s.

Given the government’s track record, it is absurd to presume the financial system will function better under more government tutelage. What will happen for sure is greater government control over the economy, moving the United States closer to state capitalism—not really a Jimmy Stewart world, more like a Mr. Bo world.

 

16 Responses to “Krugman on Banks and Romney”

  1. Marc Prosser Says:

    Hi Chidem,

    A few weeks ago, Learn Bonds put together a list of 101 Free Resources For Bond Investors. We got such a good response that we have decided to construct another list of investor resources. This time, we want to create a list for following the Federal Reserve. So far, we are not satisfied with the list and would like to improve it before we publish it on Learn Bonds. We would like your help.

    Here are two ways you can help:

    1) What resources do you use to following the FED?
    2) Should your site be included? We have noticed that many sites that we like frequently have articles on the FED, however, they don’t have a section where we can easily point an interested reader. If you have such a section, please submit it for inclusion.

    If you e-mail me, I will send you the list that we put together.

    Best regards, Marc Prosser


  2. The issue is not risk but who pays when banks lose money. Now, taxpayers are ultimately at risk. That is why JP Morgan Chase’s losses are the public’s (taxpayers’) concern. The Wall Street Journal editors got that right, and they are hardly fans of regulation.

    JPM and other large banks are operating hedge funds within the bank. They make risky bets using insured deposits and taxpayer guarantees. These activites have nothing to do with traditional banking.

    When an ordinary hedge fund losses money, its investors suffer the losses. If it looses too much money, it closes. When a major bank looses a bundle, the taxpayer antes up. Think TARP. That has been the model at least since the failure of Continental Ilinois National Bank in 1984.

    You keep ducking the central issue, which is what to do about bankers who put taxpayer money at risk. You defend them like they were mom-and-pop retailers operating in a free market. It is just not serious analysis.


  3. Peter Wallison is a banking lawyer and senior fellow at AEI. In today’s WSJ, he focuses on the most damaging part of the Dodd-Frank Act: the desigation of large financial institutions as systemically important. He correctly concludes that DFA will extend crony capitalism further in financial services.

    http://online.wsj.com/article/SB10001424052702303610504577420234053483326.html?mod=WSJ_Opinion_LEFTTopOpinion

  4. Allan Walstad Says:

    Just finished reading Vern McKinley’s “Financing Failure.” The short take-away is that regulators have long had lots of powers and nary a clue how to use them. They don’t see problems until it’s too late, then they typically shaft the taxpayer to prop up their buddies in the banking system while reciting Chicken Little stories to ward off criticism.

  5. Bill Stepp Says:

    Taxpayers are on the hook, but the solution is to get them off the hook and have a no bailout policy. Banks have shareholders. Let them assert their authority as investors, which includes hitting the “sell” button, and have the banks play their traditional roles as fiduciaries.
    Regulation erodes this function slowly but surely.

  6. Some Links Says:

    [...] Bob Murphy again challenges Paul Krugman, to good effect.  As does Chidem Kurdas over at ThinkMarkets. [...]

  7. chidemkurdas Says:

    Jerry O’Driscoll–
    Re “You keep ducking the central issue, which is what to do about bankers who put taxpayer money at risk.”

    You keep assuming that issue, that big banks have to be bailed out. I don’t think that’s a useful assumption. They should not be bailed out.

  8. chidemkurdas Says:

    Wallison In the WSJ — excellent piece.
    From its very inception Dodd Frank created opportunities for political influence and corruption, as we’ve been saying here all along:

    http://thinkmarkets.wordpress.com/2011/05/31/why-dodd-frank-is-dud-blarney

  9. chidemkurdas Says:

    Allan Walstad–
    On the basis of your comment, I will have to read Vern McKinley’s “Financing Failure” ASAP.

  10. chidemkurdas Says:

    Bill Stepp–
    Re “Taxpayers are on the hook, but the solution is to get them off the hook and have a no bailout policy.”

    That’s the nub of the matter.


  11. I could be convinced to send along a copy of FF….


  12. Here is just one example of why Chidem is off the mark in this post on banks and risk taking.

    MORGAN STANLEY DERIVATIVES PLAN DELAYED – FT’s Tom Braithwaite and Tracy Alloway in New York and Shahien Nasiripour in Washington: “Morgan Stanley’s plan to shift a large chunk of its $52tn derivatives portfolio into the part of the group backed by customer deposits is facing regulatory obstacles … Under the plan – partly an attempt to reassure trading partners of its financial strength ahead of a looming credit downgrade by Moody’s – Morgan Stanley would move derivatives into its bank subsidiary, which has a higher credit rating than the group as a whole. But the US Federal Reserve has yet to approve the request after considering it for an extended period.
    “The derivatives move should also make it less likely that counterparties take their business from Morgan Stanley to higher-rated competitors such as JPMorgan Chase even if Moody’s follows through on a threat to downgrade its credit rating by up to three notches to Baa2 from A2. Morgan Stanley’s bank is seen as a safer entity than the holding company because it is funded with customer deposits and can borrow from the Fed’s discount window”

    Morgan Stanley, which is an investment bank, is going to stuff its derivatives portfolio into its commercial bank subsidiary. MS thereby leverages deposit insurance to reduce their funding costs. The move also puts the taxpayers on the hook for Morgan Stanley’s risk taking.

    Until Chidem addresses what to do in a world in which risk taking is rapently subsidized by taxpayers, he is not being serious. Saying the government shouldn’t do it is not a serious answer.

    At a minimum, he should stop defending bank risk taking, which is being done at taxpayer expense.

  13. chidemkurdas Says:

    Hi Vern.
    Thanks. I’d like to read and possibly review it.

    Is it possible to send an electronic version to chidem.kurdas@hedgefundsmarts.com

    I’d appreciate it.

  14. chidemkurdas Says:

    Jerry O’Driscoll–
    Re “stop defending bank risk taking, which is being done at taxpayer expense.”
    My point is that all banks — for that matter, all businesses– should be allowed to fail if they become insolvent. That’s not a defense of banks but simply recognizing what they are.

    Otherwise, yes, they turn into arms of the government.

  15. Allan Walstad Says:

    Taxpayers should not be subsidizing risky behavior by financial firms. That’s a serous answer in my book. I appreciate the idea of tacking against the wind — but you’ve got to make forward progress, not backward.

  16. Bill Stepp Says:

    Morgan Stanley’s bank is seen as a safer entity than the holding company because it is funded with customer deposits and can borrow from the Fed’s discount window”

    I know how to fix *that* problem.


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