Thursday marks the penultimate installment of our extended profile of economist and New York Times columnist Paul Krugman here on Making Sen$e. The topic: What happened in the great crash of ’08? Are we in danger of forgetting the lessons learned and getting ourselves into yet another financial disaster? (Transcript below.)
Our response to Krugman comes from Russ Roberts, professor of economics at George Mason University and a research fellow at Stanford University’s Hoover Institution. He hosts a weekly podcast EconTalk and created the Keynes-Hayek rap videos with John Papola (which debuted here on Making Sen$e, and now have over 5 million views on YouTube). He blogs with Don Boudreaux at Cafe Hayek. His latest book is The Price of Everything: A Parable of Possibility and Prosperity. He has written an extended essay on the financial crisis: “Gambling With Other People’s Money: How Perverted Incentives Caused the Financial Crisis.”
And if you haven’t already, check out our previous installments:
Krugman on European austerity, with a response from Jacob Kirekegaard of the Peterson Institute for International Economics:
Paul Krugman on Germany’s ‘Whips and Scourges’
Krugman focused on Spain and Germany with critique from Terence Burnham: Paul Krugman on Europe ‘Doing the Unthinkable’
- Krugman on his former boss, Ben Bernanke: Paul Krugman on Ben Bernanke’s ‘Green Shoots’
Response: ‘This Isn’t ‘One of Those Crazy Things’
Krugman’s story of the crisis is that it was just one of those things, as Cole Porter would put it — just one of those crazy flings. One of those episodes of exuberance that markets are prone to when things are too quiet for too long. He also blames free market dogma — an ideology “that was not just pro-market but religiously pro-market that markets are never wrong, that all government regulation is bad, that government is never the solution it’s always the problem, so that we had a kind of reckless removal of the safeguards on the system all on top of what would probably have been a gradual march to crisis anyway.”
There should have been more defaults and bankruptcies that would have reminded investors of the real risks they were taking.
It’s an interesting claim. And there is something to it. There was some deregulation of the financial sector — Glass-Steagall was repealed, and some non-regulation where new products such as derivatives were left alone.
But regulation is only one measure of government intervention. The last three decades saw government intervene relentlessly in financial markets to bail out creditors of large financial institutions making it easier to borrow money and finance imprudent risk-taking with other people’s money.
In 1984, the government rescued the creditors of Continental Illinois, the seventh largest bank in the country, giving birth to the notion that some banks were too big to fail. In 1995, the U.S. government guaranteed Mexican bonds to avoid a default protecting not just Mexico but the billions of dollars that U.S. investment banks were owed and could lose if Mexico was unable to roll over its debt. In 1998, the Federal Reserve orchestrated the rescue of Long-Term Capital Management. And of course, in 2008, the government rescued the creditors of Bear Stearns, CitiGroup, Fannie, Freddie, and others. Lehman Brothers’ and Washington Mutual’s demises were the exception to the rule. The rule of rewarding creditors who financed bad bets sent the wrong signal for way too long.
Fixed-income investors–bond-holders and lenders–have a fixed upside. They only care about avoiding the downside of bankruptcy. They are the watchdogs of recklessness. But if you tell lenders they have nothing to lose, you are subsidizing recklessness. When you subsidize recklessness, you get a lot more of it. As Milton Friedman liked to say, capitalism is not a profit system, but a profit and loss system. The profits encourage risk-taking. The losses encourage prudence. Take away the losses and you get imprudent risk-taking.
Alan Greenspan called himself a free-market guy, but he supported the Mexican bailout. He supported the LTCM rescue. He invented the ‘Greenspan put’ — the manipulation of monetary policy and interest rates to bailout investors. His ideology was not free-market but pro-Wall Street. He was a free-marketer when it benefited the banks but an interventionist when markets threatened to impose losses.
So the calm of the last three decades was unnatural. There should have been more defaults and bankruptcies that would have reminded investors of the real risks they were taking. And by refusing to let creditors pay a price for bad bets, the government encouraged more reckless risk-taking. How much of the mess we’re in is due to the creation of moral hazard by government is an open question. Monetary policy played a role in creating the bubble. There was destructive housing policy. And surely human fallibility is part of the story. Just don’t tell me that what happened was the result of a hands-off government. When it comes to coddling banks and destroying the natural feedback loops of profit and loss, government’s fingerprints are everywhere.
TRANSCRIPT: ‘Paul Krugman on the ‘Cartoon Physics’ of the 2008 Crash’
Paul Solman: To what do you attribute the disaster that befell us?
Paul Krugman: I think it was largely just one of those things that happens with an assist from bad ideology. So the, the main thing that happened was we had a long period without a depression. People, very few people alive really remember the Great Depression, and very few people actually remember severe financial crisis at all in this country. And so everyone gets complacent which includes, includes politicians and public policy officials. This is the Minsky story…
Narrator: Hyman Minsky, that is, a Harvard-trained economist whose story was about booms and busts. Minsky was at one time widely dismissed bythe economics profession…
PK: But now everybody including me quotes him because one of his arguments was exactly that you have, you have a depression, you have a bad scene and everybody gets cautious and that caution gives you several decades of stability and as the stability goes on people forget the dangers and they make the same mistakes and get you right back into another one. So, so there was a natural cycle. But then on top of that you had an ideology of that was not just pro-market but religiously pro-market that markets are never wrong, that all government regulation is bad, that government is never the solution it’s always the problem, so that we had a kind of reckless removal of the safeguards on the system all on top of what would probably have been a gradual march to crisis anyway. And paraphrase Lincoln – and the crisis came. The specific probably don’t matter very much, it ended up being subprime and then Lehman Brothers, but it could have been something else. One of, one of these years we were going to have this crisis.
People, very few people alive really remember the Great Depression, and very few people actually remember severe financial crisis at all in this country. And so everyone gets complacent.
Measures of debt, measures of leverage in the financial sector, measures of household debt relative to income rose steadily and fairly rapidly especially after 2000. And then at a certain point well, so Wile E. Coyote in, you know for people not familiar with the Classics, in the Road Runner, there’s almost always a moment when Wile E. Coyote runs off a cliff and according to the laws of cartoon physics it’s only when he looks down and realizes that there’s nothing under him and … So the Wile E. Coyote moment hit in 2008 when you know, the housing bubble had started to burst, people started to look and say: There’s all that debt, oh that’s terrible, better call in those loans, better force people to repay.
PS: And that’s de-leveraging.
PK: De-leveraging. And the trouble is that there are paradoxes in all this stuff and of them is what we call the paradox of deleveraging, which is if everybody tries to pay down debt at the same time what happens is the economy shrinks, prices of assets fall and people lose their jobs, people lose their income, profits crash, and everybody ends up being in a worse financial position than they were before because they’re, they’re… When everyone tries to do it at the same time, the result is mutual destruction.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions