Response to Comments--May 16 to May 26

There were a number of interesting comments; rather than try to respond to them individually, I will group them into themes and respond to each theme.

One theme is that, contrary to my argument, the unhappy situation of the economy today should not be viewed as a "failure of capitalism" but as a failure of government. In fact both characterizations are correct, because capitalism and government cannot be separated. You cannot (here I part company with "anarcho-capitalists," such as David Friedman) have capitalism without a government, specifically a central bank with discretionary authority over the money supply and a regulatory regime for financial intermediation (banking in a broad sense). The money supply has to be geared to the amount of output--otherwise you have inflation if the ratio of money to output rises sharply or deflation if it falls sharply, and both are destructive; and because output varies unpredictably, a constant growth rate in the money supply will not avoid inflation or deflation.

And you have to have regulation of banking because banking is inherently risky (it involves lending borrowed capital, and the only way to create a spread between the cost of borrowing and the return from lending is to lend at a greater risk than that borne by the suppliers of capital to you, as by borrowing short and lending long), because the risks are not independent (that is, they are not idiosyncratic risks of particular banks), and because a failure of the banking industry freezes economic activity (which depends on credit), precipitating a severe recession or depression. So if one wants to have monetary stability and a safe banking system, one needs a central bank and a bank regulatory regime: one needs, in short, governmental controls over the economy. They are intrinsic to functioning capitalism.

What is not intrinsic to capitalism is subsidizing home ownership, whether through the mortgage-interest deduction from the income tax or the subsidization of risky mortgages by government-sponsored enterprises (Fannie Mae and Freddie Mac). I don't defend our housing policies--on the contrary. But neither do I think they are major causes of our current economic distress.

I do worry about the "moral hazard" problem--that is, the tendency of insurance to encourage risky behavior. If banks expect to be bailed out by government if they get into trouble, they will take greater risks than otherwise and get into more trouble. But we must be precise about the problem. Bailouts generally are quite painful for shareholders and management, as the financial institutions that have received government loans during the present crisis have learned to their sorrow. The principal beneficiaries of the bailouts are unsecured bondholders of the bailed-out firms, who would take a bath if the firms they lent to went bankrupt. If they think the government will bail out those firms, the firms will be able to borrow at lower cost than their competitors, and the lenders will be less vigilant in policing the borrowers' conduct.

The answer to this moral hazard problem is regulation. Any insurer has a right to take measures to reduce moral hazard, and an interest in doing so. Bank deposits are federally insured, which protects banks against runs and reduces the incentive of depositors to monitor the banks' behavior, so federal regulators, in their capacity as insurers concerned with moral hazard resulting from the insurance, try to prevent banks from taking excessive risks. If "too big to fail" operates to insure other lenders to banks, namely bondholders, then we have a further moral hazard problem to which regulation must attend.

One comment attributes our economic situation to the high oil prices last summer, and another to China's export-first economic policies, which resulted in a flood of cheap imports to the United States and a huge Chinese dollar surplus invested in the United States, which tended to keep interest rates down. I am more sympathetic to the first suggestion than to the second. I think the high oil prices, besides reducing Americans' wealth and thus making them more vulnerable to an economic downturn, fooled the Federal Reserve into keeping interest rates higher than necessary to prevent the recession that turned into a depression, because it worried that oil prices were creating a danger of inflation. The Federal Reserve raised interest rates too late to prevent the housing bubble, and then lowered them too late to prevent the bursting of the housing bubble from bringing down the banking industry.

A number of countries, not just China, which have weak domestic demand, promote exports, acquire large dollar balances, and invest them in the United States. The Federal Reserve could have offset the effect of foreign capital on interest rates by reducing the money supply by raising interest rates, as eventually it did--too late.

Another theme in the comments is the allocation of blame for the economic meltdown to the bankers. As one comment puts it, to excuse the bankers on the basis of lax regulation is equivalent to saying that because government issues gun permits, it's responsible for murder. That's fair if you think the bankers committed fraud or theft, but not if, as the comment goes on to state, they exhibited "exorbitant leverage, poor long-term risk management, and a capricious disregard for the well-being society as a whole." For that just amounts to saying that they took a lot of risk in an effort to maximize their profits, and we want businessmen to maximize their profits because, as long as business operates within the law, the general tendency of profit maximization is to minimize cost and maximize consumer welfare. If the legal framework is defective, it should be changed; competition will not permit businessmen to subordinate profit maximization to concern for the welfare of society as a whole. Ethics can't take the place of regulation. That may be a dyspeptic or cynical outlook on human character, but it is realistic.

A third theme is skepticism about my discussions of preventives and remedies for our economic situation. One comment makes the interesting suggestion that raising interest rates in an effort to burst the bubble before it became so large that its collapse did grave harm to the economy would have been a blunt instrument, since higher interest rates reduce productive activity as well as pricking asset-price bubbles, by restricting credit. But higher interest rates, by bursting the bubble early, would have freed up a lot of capital for productive investment--capital that instead went into the purchase of houses at ever higher prices.

Other comments contest my argument that regulatory reform should be postponed until after the economic downturn ends. They make the related points that the current angers and anxieties make it a politically propitious time for getting serious reform measures through Congress and that with the passage of time the banks will reacaquire and reassert their considerable political clout--political clout that in the past has defeated efforts at effective regulation. In short, in the view of these commenters, there's no time like the present for reform.

These are good points, for which I don't have a compelling answer. My concerns are with the complexity of sensible reform of banking, the limited staff resources of government to devise effective regulations while trying to execute emergenvcy measures for speeding recovery from the depression, and the negative impact on recovery of further unsettling the legal and political environment in which the banking industry is operating. But I don't how to weigh these concerns against the concerns expressed in the comments.