End the Fed

MIT Economist, Former IMF Chief Engages Ron Paul on Banking and Makes an Interventionist Mistake

 MIT Economist, Former IMF Chief Engages Ron Paul on Banking and Makes an Interventionist MistakeRon Paul’s economic philosophy and book End the Fed got some crucial publicity and thoughtful debate on Saturday. Simon Johnson, MIT economist and former IMF chief-economist,  wrote in the New York Times economics blog that more people should take Dr. Paul seriously. Unfortunately he advises Dr. Paul promote some very anti-free market, and counter-productive measures. Johnson wishes Paul would advocate a trust-busting maneuver regarding big banks.

For Johnson, a key cause of our economic woes is that the banks are too big. He advocates breaking them up to solve the problem. Why he advocates this and not doing away with the initial interventions that allowed the banks to grow so large is beyond me. One of the key aspects of the current banking system is that it allows big banks push their losses on the people with bailouts. Thus, by simply allowing them to fail instead of bailing them out, big banks would have their “power” stripped of them. Indeed, diminishing the size and scope of government prevents bankers, other large corporations, and special interests from obtaining privileges and regulatory capture.

Also, Mr. Johnson, why exactly do you despise large banks? Who are you to decide upon the best, most efficient, size of a firm which provides banking services? Such organizational decisions as the size of a firm are made on the market by entrepreneurs using economic calculation. Johnson’s position that smaller banks are better than larger banks is based upon arbitrary whim and is utterly meaningless.

Mr. Johnson writes, “The only way to restore the market is to compel the most powerful players to become smaller.” What an absurd statement! The only real way to restore the “market” is to remove the government intervention which distorts the most efficient and consumer satisfying outcomes. The myth that government action to break up large firms somehow benefits the economy (ultimately consumers) is what I intend to expose with this post.

Banks are an enterprise that provides consumers with services they value just like any other business (granted the banking industry would look a lot different on a truly free market, as in no Fed). Let take a hypothetical example to illustrate my point. What if there was a huge car company that, at some point in time, captured a massive share of the market, say 55%. They achieved this market share by providing what consumers want in the most resource-efficient way and have out-competed the other car companies. Should they be broken up on account of their size? No. Doing so would upset consumers who wanted to purchase the cars while not improving anybody in a demonstrable way. Thus, the act of coercively breaking up a firm hurts the consumers who have repeatedly demonstrated their preference for that particular manufacture’s goods. The demonstrated preference for the extra-large automaker is the necessary precondition for them to become so large. The act of breaking up a firm also demonstrably hurts the owners who have organized land, labor, and capital in the most efficient way. To break them up must cause inefficiency and the misallocation of resources. If breaking up into smaller autonomous companies resulted in a more efficient and consumer satisfying outcome, the producers would have already done so in their search for higher returns.

The concept of Pareto optimality is very important to this discussion and others relating to government policy. An action is Pareto optimal when it demonstrably helps someone and demonstrably hurts no one. All actions on the free market satisfy this requirement because they are made voluntarily. Actions that violate property rights (crimes) are not Pareto optimal. Government actions, because of their coercive nature, do not satisfy the requirement of Pareto optimality. When Mr. Johnson suggests that the best course of action is to “compel the most powerful players to become smaller,” he is suggesting an action which is not Pareto optimal. The word compel is very important. It means the owners of large banks will be forced by the full power of the state to give up control of their property. Even though the stated goal of breaking up the banks is to “restore the market,” as Johnson puts it, there is no way of knowing how many pieces the firm should be broken into. The state has absolutely no rational basis for deciding how large a firm should be, whether it’s a car producer or the producer of banking services.

Breaking up large banks via arbitrary decree of the state will not restore the market. As Rothbard (Power and Market, p. 320) points out, one intervention always leads to more complications and problems which require either additional interventions (which then require even more interventions) or a repeal of the initial intervention. If the state broke up big banks, it would also have to enact legislation to prevent small banks from becoming large. Then it would also have to enact legislation which would prevent small banks from trying to organize their assets together in such a way that mimicked the efficiency of larger banks (banks with different names the same management).

To understand how to truly restore the market, it behooves us to understand just precisely what we mean by the market. The market is nothing more than the conceptualization of the aggregation of all the exchanges voluntarily made between two or more parties. The key here is that the market is a word we use to describe the entire nexus of voluntary exchange. The fact that the exchanges must be voluntary to be considered part of the market ties us back to the idea of Pareto optimality. It is completely fallacious to say that we need a coerced reallocation of resources in order to improve the voluntary allocation of resources on the market.

The size of a particular firm is value neutral, meaning it isn’t clear whether it’s good that a firm is large or bad. We can only say that the size of firm is good or bad if we take a look at how a firm got to be so big. If the firm used government intervention in the form of regulation or a cartel like the Fed to become so large, we can say that its size is unjustified on the basis consumer satisfaction and demonstrated preferences. This is the situation with the banking industry. Bankers and politicians have been best friends since people first began using banks. Bankers have always seen the state as way to increase their size and returns while politicians have always seen banks as a source of politically expedient funding (debt and inflation are easier to slip by the average Joe than is a raise in his taxes).

Unless you remove the underlying causes for banks getting so large, they will just get large again. We must remove the existing government interventions that have allowed banks (and other huge corporations) to get so large and powerful. Advocating new interventions, as Mr. Johnson does, is not the answer.

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15 Responses to MIT Economist, Former IMF Chief Engages Ron Paul on Banking and Makes an Interventionist Mistake

  1. mart January 9, 2012 at 6:22 pm #

    More diversified banking allows for banks to survive economic crises. As in the Depression only banks that could not be investment banks and commercial banks failed. Because they lent out to say a farmer and he is also there depositor. So when he lost, they lost everything as well. Small banks that are unable to diversify there own portfolios are subject to close during hard times. Same thing in my opinion as a person. You may want to diversify your portfolio investing, hard assets, etc. Read FDR’s Folly. Great book. Shows the parallel between now and the Depression…. amazing. It is jaw dropping to be honest. We have done step by step the same thing we did to prolong the depression. Saddens me so.

  2. nfreiling January 9, 2012 at 7:53 pm #

    Jon Huntsman wrote an oped today in which he said that, if elected president (he is seeking the GOP nomination), he will “break up the big banks”. Citing the fact that the six largest financial institutions in the United States are now significantly bigger than they were in the 1990s (something he claims is at least partially the result of the collapse of Bear Stearns the subsequent acquisition of their assets at bargain prices by other firms), he said breaking up these banks will end the Too-Big-to-Fail culture, as there will be no banks large enough to incite an economic collapse were they to fall apart.

    While I can see where he is coming from (these institutions may very well not have become so large were it not for the bailouts), your piece here puts his argument in a very different light. Indeed, he is proposing a solution that is identical to what caused the problem in the first place: using coercive government power to regulate the financial sector. I’m still not sure, however, that his action does not represent simply correcting the mistake made by legislators in 2008 when they bailed out firms that would have failed altogether. Would breaking up the big banks in this way mark a step toward what an unregulated financial sector would look like? In other words, is he simply speeding up the process of breaking up these banks that may very well be so large solely because of government-subsidy?

    Here’s the link to the oped:

    http://www.foxnews.com/opinion/2012/01/07/wall-streets-big-banks-are-real-threat-to-our-economy/

    • ryanbud January 9, 2012 at 9:53 pm #

      It appears that Huntsman makes the same mistake Johnson does. He just assumes that a bank being small and “part of the community” makes them better for the consumer without critically analyzing the process by which banks (or any other business) become larger or smaller. They can either increase the scope of their operations honestly by providing a product or service consumers desire at a smaller price, or they can appeal to the government for regulatory capture and a state-backed cartel.

      Also, I think just removing the current interventions that have allowed the banks to become so large is the real solution. More intervention is unnecessary. Bureaucrats would be left with the unsolvable practicalities of actually dividing up the real resources of the banks.

    • bdzevel January 12, 2012 at 4:48 pm #

      Using coercion to “break up” one company or another is simply a subsidy for their competition. Think about that.

  3. Bayard Waterbury January 11, 2012 at 3:51 pm #

    Actually, Simon is exactly right. The big banks are not banks. They are rent seeking capitalist gangsters. The biggest banks do little to help our economy and lots to hurt it, and continue, with major assistance from the FED, to do so. However, I believe that all we would need to do to reduce the bank’s size to reasonable would be to reinstitute Glass-Steagall, which would separate actual commercial banking from all other financial operations, such as investment banking, insurance, etc., require banks to reduce leverage, i.e. increase amount and quality of capital, require that all derivatives be traded publicly and transparently, and require that credit default swaps be reserved. Once these things happened the banks sizes would shrink naturally, and we could return to real capitalism and get away from the faux capitalist plutonomy.

    • ryanbud January 11, 2012 at 4:28 pm #

      Bayard,
      You are quite right to point out that banks today are “rent seeking capitalist gangsters,” I couldn’t agree more. I do, however, have a problem with your policy recommendations. Additional regulations in the banking sector can only stiffle wealth creation and the efficient allocation of resources. More regulation would take the economy further from real capitalism (which it seems we both agree is the best system for humanity’s well-being) and bring it closer to the faux capitalist, mixed economy that reduces economic growth and the standard of living. Banks would be smaller and more diverse if regulations promoting larger banks were removed. Large corporations lobby the state for regulations that are cost-effective for them to comply with by cost-prohibitve for smaller businesses to follow. Banks do the same thing and have the Fed to continue propping them up with ultra low interest rate loans whenever they need them.

      On regulation, when people are forced by the arbitrary decree of the state the use their property in a way they wouldn’t have otherwise chosen, it can only mean lower consumer satisfaction and misallocated resources. This is because individuals on the free market seek profit. Profits are earned by best satisfying consumers. When bankers or any other entreprenuer is forced to organize his production process in a certain way by the state everytbody loses.

      Lastly, you suggest that your policy recommendations would bring banks down to “reasonable size.” Can you define “reasonable size” in any objective way? Unfortunately you cannot. Only entrepreneurs who calculate profits and losses can. Any other attempt at determining the appropriate size of a business is either based on emotion or is politically motivated via the “you pat my back, I’ll pat yours” mentality of government or a desire for power and control.

      • Bayard Waterbury January 11, 2012 at 4:47 pm #

        I would define reasonable size as the size of banks prior to the overturn of Glass-Steagall and institution of Gramm-Leach-Bliley (factored for inflation). Prior to that time (1999), the banks were all doing what banks do best, providing standard banking services to their customers. By standard banking services, I mean all forms of loans, and all forms of accounts. As it stands right now, if you look at the banking business of the largest, integrated TBTF “banking” corporations, you will note that only a very small amount of their revenues are generated by these kinds of traditional activities. So long as they can borrow endlessly from the FED at 10 to 20 basis points, and use that money for their own investment activities to generate profits by squeezing out many other market players, they are not making a true contribution to the general economy, but are, instead, actually restraining it. And, I will agree that it is not the specific size of the large banking corporations that is the problem, but simply their business model. They are presently generating some massive bubbles which, when they burst, will result in massive global financial destruction, and, perhaps the end of mankind. No joke. If you don’t realize this, you are guilty of capitalist myopathy.

    • csfuller January 11, 2012 at 4:32 pm #

      The size of a firm has nothing to do, necessarily, with whether it exists in a capitalist system or not. The point of Ryanbud’s post is that, to the extent that banks have become large due to government privilege, their size is illegitimate. To the extent that they have become large through satisfying consumer preference, their size is legitimate. It may be impossible to tell how much of their size is from which cause in our jumbled climate of government intervention. The only sound way to tell would be to repeal much of the intervention.

      • Bayard Waterbury January 11, 2012 at 4:52 pm #

        Dodd-Frank should be mostly repealed and simplified. Add back Glass-Steagall, and the CFPB, and a requirement to have derivatives listed and traded publicly, and credit default swaps to be subject to reserves, and, finally require strong capital ratios (even stronger than Basel II. I think, like you do, simpler, more effective, regulation is definitely better, just like a smaller, simpler tax code. And, vigorous enforcement.

      • bdzevel January 12, 2012 at 4:50 pm #

        <3 this answer, thank you for bringing a bit of hope back into my heart.

  4. Reason Thus Liberty January 17, 2012 at 12:12 am #

    I like the argument that in a free market the banks wouldn’t be this big. Could you give a list of ways that government allows them to become that big?

    • krlatham January 17, 2012 at 12:40 am #

      The most important is the existence of a central bank. In free banking, banks can’t simply print paper money as they wish. Competing banks redeem paper money for commodity money with each other, so banks must keep enough reserves to satisfy both consumers AND competing banks. In central banking, banks redeem paper money at the central bank. This eliminates the check that competing banks hold on one another. So now banks must only hold enough reserves to prevent a bank run from customers. The analysis holds true even without commodity money, as banks redeem other money substitutes (like account balances) for paper money.

      Another reason is the process inflation itself. The people who receive freshly printed money first benefit at the expense of later users. Prices rise as the money supply increases. So if I get the money first, I can buy stuff before prices rise. People who get it last have already been paying higher prices. Banks or the treasury department receive this new money from the Fed first. Either the Fed buys treasury bonds and gives the government the advantage, or it lower reserve requirements. This lets banks create more money to spend, giving them the advantage. This advantage is instrumental in expanding the abnormal size of the banking industry.

      Also, don’t discount bailouts themselves. When a government gives banks huge amounts of money, its only natural for them to swell in size.

      For a longer list (and perhaps clearer explanation) go here: http://mises.org/books/mysteryofbanking.pdf
      The important chapters for your question are 8 and 9, but the entire book is worth the short read.

      • Reason Thus Liberty January 18, 2012 at 2:29 pm #

        Keep up the good job!

  5. BrucieB January 24, 2012 at 3:32 pm #

    It’s simple follow U.S. Constitution with regard to currency law, back minimalist law like Glass-Steagall, have non-binding public plebicite for major bank rules.

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