King Krugs' Court

Ok ok, I wrote a Krugman reaction piece. I hate writing Krugman reaction pieces, although I've done it once or twice before, because it's just so… cliche.  You see, Paul Krugman is the (disputed but) undeniable King of the Econ Blogosphere, aka the Econosphere. For starters, he's the only nobel prize winner who gives a shit about the internet.  He also writes for the New York Times, and has an aptitude for headline writing that's almost uncanny for a professional economist.  Most importantly, he's opinionated and… searching for the right word… let's go with "pugnacious." His pieces either evoke hurrahs from supporters, or anger from critics. The former doesn't generate much interesting content (you can state agreement in under 140 characters, including a link) but the latter is responsible for an embarrassingly large percentage of all posts published to the amorphous mass that is the Econosphere.

Your rank in the Econosphere is roughly approximated by your degrees of separation from Paul Krugman. If he links to you frequently, you're in tier one and probably a professional economist. If he links to you sometimes, then you're in tier two, and you may be a professional economist at a backwater school, an articulate graduate student, or a particularly with it mainstream media journalist. If he links to someone who links to you, you're in tier 3. And then there are people like me, who are neither professors nor students nor paid to write about economics, and who no one links to. (But hey bubs, I'm blogging to learn). 

I thought it would be fun to plot King Krugs' Court, so I've done so below. As a bottom feeder and part timer, my perspective is skewed, and I've probably left out important subjects. 

When I finished making this, the feminist in me realized that their was only one woman in King Krug's Court, and that she writes with a male pen name. The feminist in me wanted to go out of my way to find more female courtiers, but then the rest of me decided against it. The feminist in me wondered if the rest of me is unconsciously sexist. The feminist in me wanted to curl up in a ball and cry. 

ANYWAY, on to the Krugman reaction piece.  

Last week Krugman wrote a cursory piece called "Generation B (For Bubble)" which argued that low interest rates or "easy money" have not been historically correlated bubbles, and that the true culprit and root cause of the financial crisis was actually financial deregulation. I buy the bit about the rates not really mattering.  What I don't like is the bit about financial deregulation. He may actually be right, but I find his lack of elaboration extremely frustrating. 

There certainly was a lot of financial deregulation that occurred in the 1990s. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 allowed financial institutions to open branches in other states, following up on deregulation that had had been occurring at the state level since the 1970s, and the FSA negotiations in 1995 made it easier for foreign banks to operate in the US. Both of these deregulations coupled with the advent of the internet increased competition in the banking sector; the community bank that once has a more or less monopoly control over its locality suddenly had to compete with regional and national banks opening branches on the next block.  Increased competition may have encouraged banks to make riskier loans, but it also increased efficiency and made financial services more accessible to the poor.

The Gramm-Leach-Bliley Act of 1999 repealed the artificial separation between investment banks and commercial banks created by the Glass -Steagall act of 1933, and (in the paraphrased words of another unremembered blogger) "created the monstrosity that is Citigroup."  But wait a second, what role did Citigroup have in the financial crisis? I read Too Big To Fail, and I  remember fewer frantic phone calls between Henry Paulson and Vikram Pandit, the CEO of Citigroup at the time, than between Henry Paulson and Dick Fuld, the CEO of Lehman Brothers, and Henry Paulson and John Thain, the CEO of Merrill Lynch, both independent investment banks.  Bear Sterns, another standalone investment bank, was the first to fall.   Citigroup's investment banking arm made poor choices and got in trouble, and received their taxpayer bailout, but without its marriage to Citibank, the outcome may have been even worse.  And as we know, Merrill was saved only by a Treasury-engineered sale to Bank of America, a move that would not have been possible without GLBA. Some might argue that that the repeal of Glass-Stegall increased the moral hazard of investment banks by tying federally insured consumer deposits to uninsured investment activities, and Stigliz thinks investment banks poisoned the commercial banks with their "high-stakes, high-return culture," but I'm a doubter.  The trend toward greater risk started before the GLBA, and was not caused by it. 

I'll give Krugman and any others who want to scapegoat deregulation the Alternative Mortgage Transaction Parity Act of 1982. That was probably a bad call. 

Yes there was a lot of financial deregulation. But the greater culprit was financial innovation and the inaction that accompanied it.  The first collateralized debt obligation was issued by Drexel Burnham Lambert in 1987.  The first credit default swap was created Blythe Masters and a team of crackshot JP Morgan analysts to get around a tricky Exxon Mobile deal in 1994.  These new tools, coupled with greater utilization of other types of derivatives and higher leverage across the industry, led to the bubble, which led to the burst. This is nothing new; at the root of many a historical financial panic lies with financial innovation that people at the time misunderstood, misused, and under-regulated.  The culprit here was not deregulation, but failure to appropriately add or adjust regulation, a distinction that I think is important. 

The greatest culprit however, may have been financial regulation itself. Fannie Mae, Ginnie Mae, and Freddie Mac were created to help Americans achieve the dream of owning their own home.  Ginnie Mae was responsible for issuing the first mortgage pass-through security, the forerunner of the infamous mortgage backed security that when traunched and bundled so elegantly concealed the true risk of the sublime lending market. WIthout the GSEs, the mortgage crisis would probably not have happened. 

Let's sum it up. How did this happen? 

1) Deregulation increased competition and squeezed institutions reached for profit at greater risk 
2) Inaction in the face of innovation turned out to be not such a good idea 
3) Regulation intended to help people ended up blowing up the economy

My point is, the answer is rarely as simple as "More Regulation!" or "Less Regulation!" or "Leave it be, it'll be fine!" You can get screwed by doing any one of these things. You can also get screwed by not doing any of these things. To imply that the 2008 crisis was caused by deregulation alone is simplistic and misleading, and won't lead to smarter policy.


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