Magazine | October 5, 2009, Issue

Krugman’s Scapegoats

Rebutting the Times columnist’s attempt to pin the market meltdown on the Chicago School

Hard times demand scapegoats. And demand in the scapegoat market is high right now, with economic malaise lingering after last year’s financial meltdown and bank bailouts. One much-abused scapegoat is the free-market economics of the Chicago School  (after the University of Chicago, where many of the school’s proponents made their academic home). The basher-in-chief is Princeton economist and New York Times columnist Paul Krugman, who demanded, “How did economists get it so wrong?” in a recent essay. Krugman’s answer heaped scorn on his Chicago foes, who, he argues, were so blinded by the beauty of their mathematical models that they drove the nation into a deep recession. The only salvation, he says, is the warmed-over Keynesian pump-priming he has long advocated. 

Krugman is wrong about both the cause of and the cure for our current mess. A true academic, he operates under the delectable delusion that a credentialed economist (never mind a Chicago School economist!) has a sole hand on the economic-policy tiller. Though the former Princeton professor Ben Bernanke heads up the Fed, huge swaths of economic policy have been shaped by political operatives such as Karl Rove and Rahm Emanuel. At the same time, Barney Frank and Christopher Dodd — not exactly Milton Friedman acolytes — head key congressional banking and finance committees. Whatever witch’s brew they concoct, they don’t use free-market ingredients. 

So it is worth asking two questions. How did we get here? How do we get out?

In Krugman’s macroeconomics-dominated world, the first place to look for answers is monetary policy. His Times tirade gloats that former Fed chairman Alan Greenspan — backed by Obama’s economist-in-chief, Larry Summers — mistakenly rejected calls to rein in subprime lending and to stanch the Fed’s flow of cheap money. A grand blooper, to be sure, but not one that originates in Chicago-style economics: No Chicago economist supports either policy. Cheap money sets interest rates at or below the level of inflation — which is to say, it’s a policy of giving away free cash, but only to those who bid up housing prices. 

On top of all that, the lax lending-and-guarantee policies of Fannie Mae and Freddie Mac induced private banks to do exactly what we should expect of rational actors: lend on the strength of Fannie and Freddie’s implicit government guarantee rather than on the dubious value of the properties in question. The Hoover Institution’s John Taylor has offered powerful evidence in his pithy book Going Off Track that these wrongheaded policies led to a huge artificial run-up in housing stock — a development that the Chicago School’s sound monetarist polices would have significantly dampened. So Chicago’s response to Krugman on the first count of the indictment is a proud “Not guilty.”

Krugman also misfires by implicitly treating monetary policy as the only game in town. His article never mentions the roles of securitization and mark-to-market accounting in forcing Bear Stearns and Lehman Brothers over the edge. Securitization turns out to be a mixed blessing. By cutting mortgages into slices that could be recombined in finely calibrated tranches, the wizards of Wall Street diversified geographical risk while allowing financial institutions to buy investments tailored to their portfolios. Credit-default swaps offered the illusion of insurance. Credit-rating agencies offered the comfort of a Triple-A certification. 

Unfortunately, it is a law of practically Newtonian inevitability that every advance in financial technology brings with it offsetting disadvantages. Securitization was intended to help manage banks’ risks, but it took away an important incentive: Banks originating mortgage-backed securities relaxed their underwriting standards because they knew they could count on guaranteed sales. That deterioration in lending quality really bit when bad times hit — but only after those securities had insinuated themselves throughout the global economy. The quantitative analysts (the math geeks who created the new securities) had had to make certain assumptions about mortgage-default rates and what changes in housing prices would do to them. Unfortunately, they had underestimated the volatility that regulation adds to the mix and had failed to account for the legal protections for mortgage borrowers. They had not done well in assessing the negative impact that systemic delays in mortgage foreclosures would have on underlying real-estate values. They had not accurately priced the statutory “rights of redemption” that in many states allowed homeowners to reclaim properties cheaply after foreclosure. And they had badly underestimated how complicated it would be to renegotiate existing loans on a mass basis, especially when many underwater homeowners were opting simply to stop making mortgage payments while barricading themselves in their homes with a big assist from consumer groups.

Other government errors compounded private-sector failures. First, SEC regulations kept new entrants out of the securities-rating game. Weak information led to unwarranted reductions in the credit ratings for some mortgage-backed securities, which in turn triggered demands for massive infusions of capital to bolster the banks and other institutions that held those downgraded assets. That, in turn, required the afflicted banks to call in loans, sell assets, and seek new investors to beef up their capital reserves. At this point, another SEC favorite — mark-to-market accounting — accelerated the downward fall. When one bank was forced to sell assets, mark-to-market required all the banks to revalue similar assets at the new, substantially lower prices, further depleting their capital cushions and triggering further destructive rounds of forced selloffs and revaluations. 

When the financial health of competing banks is uncorrelated, one bank can fetch a decent price by selling off its assets in a market with lots of buyers. But when banks’ losses are correlated — and mark-to-market and other regulations helped ensure that they were — there simply is no market. Rational buyers stay on the sidelines, knowing that the coming sale of assets by one bank will send prices tumbling and force other banks holding those same assets to mark down their prices, which means that they, too, will have to sell. What we have then is a downward cascade in asset prices that stops only after they have fallen well below the value of the underlying securities, usually understood as the discounted present market value of their future cash flows. Those cascades exposed the danger of the Bush administration’s decision to ease reserve requirements for fancy interbank transactions. Credit-default swaps, a form of default insurance that, for regulatory reasons, had migrated to AIG, collapsed under the weight of that avalanche. And the whole system went down. 

It’s easy to quibble about the relative proportions of private and public mistakes. But however the blame falls, Krugman is wrong to lay it at the feet of Chicago School economics, which holds that if the government offers a guarantee against bank failures it must also exercise bank oversight.

But Krugman needs to knock the Chicago School out of the intellectual marketplace to make room for his preferred policies, especially the use of Keynesian stimulus spending to jumpstart the economy. And if he is lucky, his denunciation of the alleged failures of the Chicago School might distract the public from the fact that his beloved Keynesian stimulus has been a bust. Keynes’s case for pump-priming may have made sense with Depression-level income taxes, which Hoover’s 1932 Revenue Act raised to a top marginal rate of 63 percent. High taxes force the substitution of inefficient public investment for sensible private investment, and FDR compounded the mistake by blessing, between 1933 and 1935, literally hundreds of industrial and agricultural cartels that killed market innovation and price competition. A better strategy today would be to get rid of the pork, lower marginal tax rates, and eliminate agricultural subsidies and protectionism. But the Obama administration is defiantly marching in the opposite direction: Tax rates will rise in 2011, if not sooner; tariff walls will remain high; unions flex their muscles; and free trade remains under siege as Chinese tires face ill-advised anti-dumping duties.

What makes this already toxic environment worse is the heightened risk of regulatory expropriation. The contretemps over the AIG bonuses was not just about $165 million in compensation. It was about the protection of contracts against government interference; if AIG employees can be browbeaten, so can everybody else. The scandalous terms of the Chrysler and GM bankruptcies sent out an equally strong signal that creditors’ established priority arrangements — a Chicago School imperative — could be upset by political interference. Obama’s approach, so far, relies on sham asset sales that allow politically connected unions to receive preferential treatment over other creditors as a payback for their support. It is not liquidity, as Krugman supposes, that keeps cash at home. It is a quiet, desperate want of confidence that business can be done on honest terms. 

Matters get worse on the employment side of the picture. The vaunted Obama stimulus package was supposed to keep unemployment rates below 8 percent. Instead they are creeping toward 10 percent, with an attendant fall in real wages. The generic explanation is that higher taxes and heavier regulation drive down the demand for labor when product markets are roiled by political uncertainty. 

Beyond macroeconomics, microeconomic blunders add fuel to the fire. Krugman might have noted that the recent increase in the minimum wage is particularly deadly in the face of falling real wages, especially to workers with few advanced skills. More important, he could have acknowledged that the hare-brained scheme of labor regulation embodied in the misnamed Employee Free Choice Act (EFCA) is a first-class job killer: Who wants to open a business in which a union created by dubious card-check procedures can force the acceptance of a two-year contract dictated by Obama’s Department of Labor? The EFCA is dormant for the moment, but so long as organized labor has clout at the White House, dormant ain’t dead. As if that weren’t bad enough, the prospect of a crudely nationalized health-care system, coupled with the nightmare of a Byzantine cap-and-trade program, will put lots of sensible investments on hold and lots of jobs on ice. Investors want to know what kind of economy they are investing in.

Krugman’s response is to ignore these particulars and issue a call to embrace modern behavioral economics, with its laboratory experiments and endless surveys. But none of that fancy theoretical stuff can begin to justify any of the big-ticket regulatory initiatives Obama wants to foist on the country. Nor can it fix, in some mysterious way, the ills of financial markets. I agree that the Chicago view of efficient markets (the hypothesis that market prices instantly reflect all known information) can’t explain the meltdown, but it helps explain the other 99 percent of the financial landscape. Behavioral economics explains neither. What is needed is some systematic explanation of the linkage between the volatile 1 percent and the predictable 99 percent: When do market trades deviate from fundamental values, and why? My guess is that the answer will likely be found in a better understanding of the interactions between experienced and novice traders. 

Krugman offers no fresh ideas of his own; he only vilifies Chicago. His macroeconomic fixation blinds him to the core of good sense in the Chicago School, which argues: Let’s reduce government interference in competitive markets; let’s support strong property and contract rights; let’s invest in sensible public infrastructure, such as law enforcement; let’s adopt a decent anti-monopoly policy; and, yes, let’s promote a stable currency and adopt low, flat taxes. 

We haven’t done any of that. So, in a sense, Krugman was right to ask, “How did economists get it so wrong?” He should start by asking himself.

– Mr. Epstein is a professor of law at the University of Chicago, a senior fellow at the Hoover Institution, and a visiting professor at New York University’s law school.

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