An idealistic defense of pragmatism

Conservatives often ask me how I can in good conscience defend the Federal Reserve System.  Why don’t I advocate letting markets set interest rates, letting markets set the money supply.  Why not advocate free banking.  Etc., etc.

I would argue that I am doing this, and more.  You just aren’t paying close enough attention.  Milton Friedman wanted to show that tight money caused the Great Depression in order to get better monetary policy.  But an even bigger reason was to show that capitalism worked and that socialism wasn’t needed.

I’m trying to get the Fed to target NGDP so that we can have a more capitalistic economy, without feeling that if we don’t bail out GM, the unemployment rate might rise.  My hope is that if we do this, eventually we’ll see the obvious need for a NGDP futures market.  And that will lead us to see the obvious need to target NGDP futures prices, and let the market determine the money supply and the interest rate.  And then we’ll abolish TBTF, as we’ll no longer fear that big bank failures will lead to recessions.  And then we’ll abolish FDIC.  And then we’ll allow free banking; after all, even if a few wildcat banks fail it won’t affect the macroeconomy.  But it matters how you do this.  Go to wildcat banking without first getting rid of deposit insurance and you end up like Iceland.

If I was a politician I wouldn’t advocate 100% libertarianism, even if I believed in 100% pure libertarianism (which I don’t).  I’d advocate removing the worst abuses of government, the ones that are easiest to see.  I’d doing this knowing that many of the other problems in our society are produced as the side effect of well-meaning regulation (as when FDIC and TBTF led to excessive risk taking.)  Each time we peel back one layer of government, society begins to restructure in a more effective way, and people will start to see how other layers of government are causing problems.  Then they can be peeled back.

A recent Bryan Caplan post triggered this post:

Tyler often insists that, appearances notwithstanding, he’s constantly popularizing free-market ideas.  People just have to read him carefully and in the proper frame of mind.

I habitually insist that this isn’t good enough.  Either you popularize your point bluntly and clearly, or you fail to popularize.

I’d say both Cowen and Caplan are valuable, but in different ways.  Caplan keeps expanding the argument for libertarianism.  Defending the seeming indefensible with surprisingly persuasive arguments.  Cowen’s value is much less obvious, but arguably just as important.  He shows that someone who is extremely bright, seemingly open-minded, and often willing to take on the dogmatic libertarians, can still end up with a preference for small government.  One could argue that the best argument for libertarianism is that someone like Tyler Cowen could be even a moderate libertarian, just as the best argument for progressivism is that someone like Matt Yglesias could be a progressive.  It’s easy for me to dismiss 99.9% of progressives, as I see right through their biases, their lapses in logic, their lack of understanding of economic principles, their shameless misuse of statistics.  It’s not so easy to do that with Matt Yglesias.  I’d guess many progressives feel that way about Tyler Cowen.  If there were no Tyler Cowens we could easily be dismissed as a bunch of moonies.  With him, it’s not so easy.

PS.  It’s possible that Bryan’s post was about style, and this post is about substance.  So I may not actually be addressing the point raised in Bryan’s post.  I’ll let you guys decide.

PPS.  Another way to make this distinction is that in a world full of government intervention, where some policies may be defended on “second best” grounds, there’s a big difference between starting one’s analysis with the premise that libertarianism is TRUE, and that we just need to work out the implications for policy, and starting one’s analysis with no assumptions about libertarianism (or perhaps just a mild preference based on past experience) and then using the tool kit of modern economics in whatever direction it takes us.

PPPS.  I do agree with Bryan on one point.  Tyler is too vague about how the Great Stagnation costs jobs.  I can sort of see how there might be some indirect effects (minimum wages, UI, SSDI, etc), but I think those need to be spelled out much more clearly.  It’s not enough to say we’ve lost jobs in declining industries–we always lose lots of jobs, even in boom years.  I suspect I might even agree with Tyler to some extent, but I also suspect the mechanism isn’t what a lot of readers would assume.

PPPPS.  I agree with Bill Woolsey’s new post–central banking involves much less “central planning” that it might appear.


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27 Responses to “An idealistic defense of pragmatism”

  1. Gravatar of A. Carraro A. Carraro
    16. August 2011 at 08:39

    You seem to imply that FDIC has negative value.

    I would think that the moral hazard cost is at least counterbalanced by the reduced calculation costs (I, and every other agent in the economy, don’t need to spend time worrying in which bank to put my money). Historical cost of deposit insurance are relatively small and, while I understand the benefits are difficult to value, there must be…

    Surely it’s better that we all agree to fund a common police force rather than each of us funding our own protection agency.

    I think it doesn’t matter if a solution is market based or goverment/regulation based as long as it’s the best we can devise. I would go as far as saying that most of the time market based solution are better, but we do know there are fallacies in market behaviour and we need correction mechanisms…

    I find very frustrating when people say “market is always better” or “goverment is always better”. We have so little understanding of reality that generalizing is totally useless. Let’s discuss a single issue at the time and argue what the best framework for that particular problem is.

    Arguing that capitalism is complete freedom is meaningless. The law of the jungle is complete freedom. I don’t think anybody thinks that’s the best system. So let’s agree which rules are useful and which are not…

  2. Gravatar of Scott Sumner Scott Sumner
    16. August 2011 at 08:48

    A. Carraro, The cost of deposit insurance has been huge–a massive misallocation of resources to the banking sector, and then to property development. It was a major factor in the recent financial crisis.

    I have no problem with the private sector producing deposit insurance for small savers. Large savers should either invest in T-bonds, or else monitor where their funds are going.

    You said:

    “I think it doesn’t matter if a solution is market based or goverment/regulation based as long as it’s the best we can devise. I would go as far as saying that most of the time market based solution are better, but we do know there are fallacies in market behaviour and we need correction mechanisms…
    I find very frustrating when people say “market is always better” or “goverment is always better”. We have so little understanding of reality that generalizing is totally useless. Let’s discuss a single issue at the time and argue what the best framework for that particular problem is.
    Arguing that capitalism is complete freedom is meaningless. The law of the jungle is complete freedom. I don’t think anybody thinks that’s the best system. So let’s agree which rules are useful and which are not…”

    I agree 100%.

  3. Gravatar of A. Carraro A. Carraro
    16. August 2011 at 08:55

    I also disagree that you would solve the TBTF problem. I work in finance. When Lehman went down, all we, and every other institution in the street, did for a week was figuring out what it meant for us…

    Whatever you think of the productivity of the finance sector, that certainly had costs for the real economy. You cannot eliminate that cost.

    You can split banks, but that will generally have cost on efficiency of scale and diversification.

    The extrenalities on a bank default are more expensive than defaults in other businesses. Finance is complicated, always has been, always will be.

  4. Gravatar of Scott Sumner Scott Sumner
    16. August 2011 at 09:05

    A Carraro, Without TBTF there is no way that Lehman would have ever got so leveraged in September 2008. I’m sure people lending them money in mid-2008 thought “we can’t lose, look how they bailed out Bear Stearns.” The costs of moral hazard are huge.

    I’m trying to reduce moral hazard precisely because I think these financial panics have a huge impact on the economy. So I certainly agree that finance is important.

  5. Gravatar of A. Carraro A. Carraro
    16. August 2011 at 09:17

    I find it diffucult to believe that deposit insurance was the cause of the financial crisis.

    I think a better description of what happened is that banks invented CDOs and SIV to lend to the property market at higher leverage than they traditionaly did. Crucially most of those new vehicles funded on the commercial paper market (where there is no deposit insurance) since they where considered triple-A. If you remember, the Fed had to guarantee the commercial paper for exactly this reason.

    CDO are effectively small S&L banks that are not subject to regulation.

    It’s true that the banks had to take most of the assets in the SIV once the commerical paper market stopped working (which meant the FDIC was now liable). But full liability didn’t stop buyer of commerical paper from buying what can be technically described as sh*t in the first place.

  6. Gravatar of George Selgin George Selgin
    16. August 2011 at 09:41

    For whatever it may be worth, though I think that he and Bill Woolsey are wrong to dismiss the comparison of central banking with central planning (see my comment on Bill’s post), I’ve always considered Scott’s proposals and those favoring a move toward free banking to be complementary schemes for making discretionary manipulations of the supply of base money unnecessary, and for thereby ruling out the possibility of discretionary monetary policy errors.

    I only wish, now that his blog is so popular, that Scott would draw inspiration from Cato the Elder, andend each of his pleas for replacing current Fed practice with NGDP targeting with: “For the rest, I believe that the Federal Reserve System must ultimately be destroyed.”

  7. Gravatar of A. Carraro A. Carraro
    16. August 2011 at 09:50

    I admire your positions on monetary policy and I think you are a very insipired economist, but I think you are simplistic in your analysis of modern finance.

    I am an insider so I am biased, but saying that without TBTF lehman wouldn’t have been so leveraged is very optimistic.

    Calculating leverage (and I assume you really mean risk) in a modern bank (with all its derivatives positions) is almost impossible for insiders. Hoping that outsiders (without any knowledge of the real positions) could do that is unlikely. We devote a massive amount of energy in trying to understand the risk we are running, and we hope we get it mostly right, but sometimes the world it’s too complex and changes too quickly.

    You could argue we should really simplify banks, but you cannot really do that. True we have some new products, and some new pricing formulas, but the risk we take are the same as they have always been. Derivatives have been invented hundreds of year ago. The packaging might be slightly different, but the stuff inside is the same…

  8. Gravatar of Jameson Jameson
    16. August 2011 at 10:30

    I’ve been following Tyler Cowan’s blog for a while, and I have to say, he is a bit cryptic to the non-expert (I’m just a mathematician, what do I know about economics?). But I appreciate having such intellectual libertarians out there–an economist who posts about P = NP!

    But anyway, the economics blogosphere is fascinating because of the inherent tension in economics between the science and the ideology. Economists have an epistemological problem that most of us don’t: are these theories explaining things or driving things? Do we want to understand society or steer it in the right direction? I suppose all the social sciences have this problem; but in economics it’s more interesting because of their relative prominence in the world of politics.

    I enjoy reading this blog. Maybe if my fantasy career in mathematical economics ever takes off, I’ll be more competent to contribute something more interesting.

  9. Gravatar of Jameson Jameson
    16. August 2011 at 10:31

    Sorry, Tyler *Cowen*

  10. Gravatar of johnleemk johnleemk
    16. August 2011 at 12:03

    Scott,

    So your implication is FDIC would do more good/less harm if the insured limits were much lower, which I suppose makes sense. It’s really shocking to me how much they insure. $250,000 a pop…that’s crazy.

  11. Gravatar of cassander cassander
    16. August 2011 at 16:41

    It seems to me that, if anything, recent history has proven the uselessness of central bank independence. The story I was always told was that the independent bank was a noble lie. Central banks obviously wasn’t independent, but the fiction bought better policy. However, I no longer believe this to be the case. In good times, central bank independence doesn’t do any harm, but it doesn’t do you any good either. And in bad times maintaining the illusion of independence becomes a hindrance to coherent, coordinated policy. If the Fed was an office of the Treasury department, does anyone really think that pre-crisis policy would have been any worse?

  12. Gravatar of Scott Sumner Scott Sumner
    16. August 2011 at 17:30

    A. Carraro, I view the massive bailouts of FDIC and the GSEs as “the crisis” so ipso facto I think it caused the crisis. What others falsely refer to as “the crisis” (the problems big banks had after Lehman failed), I consider “a crisis,” much less important. Those loans were repaid.

    George, I agree with those general policy inclinations, I just think “central planning” is too strong a term. I think of a central planner as someone who controls many prices. The Fed basically controls one–the price of money.

    I guess if you also noted it’s regulatory role, you could make a stronger argument, but that’s not what most critics seem to be focusing on.

    A. Carraro, I think I know enough about modern finance to know that there’s a huge difference between bank debt viewed as safe as T-bonds and bank debt that might well default. I also observe that the stock market is often able to see when banks are getting into trouble. I’m not saying that big banks would never be in a position to fail if not for TBTF, but I think it would happen less often–they’d be more conservative.

    Regarding deposit insurance, banks were far more conservative back in the 1920s before deposit insurance. It’s not even close. Banker had to work very hard to earn the trust of their depositors. There were no “subprime mortgages.”

    Thanks Jameson. You said:

    “Do we want to understand society or steer it in the right direction?”

    Both, we need the first to do the second.

    Johnleemk, Yes, $10,000 or $25,000 would be much better.

    Cassander, I agree.

  13. Gravatar of acarraro acarraro
    16. August 2011 at 21:25

    I think you underestimate the effect of the transformation to limited liability companies.

    Bank shareholders were wiped out in this crisis, hardly a ringing endorsement for the control exercised by the equity market. Just because equity prices collapse before a bank goes bust doesn’t show anything. I think the agency problem between managers and shareholders is much bigger than the effect of deposit insurance. I think some sort of limited or unlimited liability for bank managers/employees would be a better approach.

    Plus the FDIC is already mostly funded by a levy on the banks themselves (which will go up in the future to claw back any past losses). So it’s a bit like an unemployment saving account which you like somewhere else.

    Sure $250,000 is a large amount, but people and business have fluctuating cash balances. A business could have just received a payment from a client and need to pass that to suppliers. You could have just sold your house. There are a lot of reason while you could have an abnormal cash balance at one point.

    I hardly think the banking sector was less prone to collapses before the FDIC. Certainly there was no FDIC during the great depression and while you are the expert, I would bet they had more banking crisis before the insurance than after.

    As far as the GSE are concerned, that is hardly the only scheme in favor of home ownership. Mortgage interest deductability is likely as big an incentive. Plus housing and debt booms (and sub-prime mortgages) were observed in other markets with neither feature (like the UK), so maybe something else was going on.

    I think banking crisis are like earthquakes or other natural disasters. We can prepare for them, but they will happen in the future. When they do happen

  14. Gravatar of acarraro acarraro
    16. August 2011 at 21:32

    Plus the banking sector is like a formula 1 engine. If it doesn’t break sometime, it means you are not squeezing all the performance you could. That buffer has costs and it’s not obvious the crisis wipes out the additional wealth you create by testing the limits.

    You also argued that ’00 housing construction wasn’t that unreasonable compared to historical housing construction and social changes (smaller average family size).

    Isn’t it inconsistent to argue that GSE distorted the market then?

  15. Gravatar of James in London James in London
    16. August 2011 at 23:29

    acarro said: “I would think that the moral hazard cost is at least counterbalanced by the reduced calculation costs (I, and every other agent in the economy, don’t need to spend time worrying in which bank to put my money).”
    Either you don’t have much money, or you are a fool (as in “a fool and his money are easily parted”). If you have some money then you should very much worry about which bank to put it in. If you have (had) children you would certainly worry about which school to put them in.

  16. Gravatar of A. Carraro A. Carraro
    17. August 2011 at 00:42

    I do worry, but worrying has a cost. I spend time worrying where to deposit my money rather than analysing which investments to make. When the crisis hit, I opened accounts with all banks, because (given current legislation) it was equivalent to buying t-bills, but paid a better rate. Most people I know did that at least in part.

    There are already people that should worry about banks (shareholders and bondholders). Why do you think that adding a third (likely less informed) layer of people should improve the picture?

  17. Gravatar of A Way To Free Banking « Retronomics Blog A Way To Free Banking « Retronomics Blog
    17. August 2011 at 05:49

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  18. Gravatar of flow5 flow5
    17. August 2011 at 05:53

    The disproporationate FDIC assessments are due to monetary mis-management. If ngDp was properly targeted the amounts would be much lower.

    Paul Kasriel (Northern Trust) advocates using a credit proxy to target ngDp. Kasriel leaves out “MSBs” though:

    The deposit taking (money creating), financial institution’s (DFIs) bank credit equals the sum of commercial bank, S&L, credit union, & MSB credit. This seems better than using the better-late-than-never “Taylor Rule”.

  19. Gravatar of flow5 flow5
    17. August 2011 at 06:01

    Bank debits represent the best proxy for ngDp. For the Keynesians, aggregate monetary demand is nominal GDP, the demand for services (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

    Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal “engine” of inflation – which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. Bank debits encompasses the total effect of all these monetary flows (MVt).

  20. Gravatar of W. Peden W. Peden
    17. August 2011 at 06:12

    flow5,

    I thought I followed you, but I was confused by this statement-

    “Bank debits encompasses the total effect of all these monetary flows (MVt).”

    – if people move money from, say, M3 or M2 to M1 via putting something in a demand deposit, how is that a bank debit?

    Actually, as I type that, I think I see what you mean: by “bank debit”, you don’t just mean something like a bank debit from a current account into cash, but ALL bank debits from ALL accounts? If so, I finally comprehend what you’re saying, which is the result of quite some time puzzling over your comments here and elsewhere.

  21. Gravatar of W. Peden W. Peden
    17. August 2011 at 06:30

    * Finally BEGIN to comprehend…

  22. Gravatar of Scott Sumner Scott Sumner
    17. August 2011 at 14:32

    A, Carraro, You said;

    “Plus the FDIC is already mostly funded by a levy on the banks themselves (which will go up in the future to claw back any past losses). So it’s a bit like an unemployment saving account which you like somewhere else.”

    No, it’s completely different. One is a tax, and one isn’t.

    You said;

    “Sure $250,000 is a large amount, but people and business have fluctuating cash balances. A business could have just received a payment from a client and need to pass that to suppliers. You could have just sold your house. There are a lot of reason while you could have an abnormal cash balance at one point.”

    Sure, but that doesn’t mean we should have a government insurance fund. My house is worth more than $250,000, but the government doesn’t insure it. Another idea is to have both insured and uninsured deposits. The insured deposits will offer lower rates, but be fully backed by T-securities on the asset side of the bank balance sheet.

    “I hardly think the banking sector was less prone to collapses before the FDIC.”

    Small banks in America were a problem due to branching restrictions (not in Canada.) Certainly large banks behaved much more conservatively before FDIC. Canada didn’t have FDIC until 1966–and had no problems. We don’t need it.

    We agree on mortgage interest deduction–a very bad policy. And there are others such as FHA, etc.

    You said;

    “Plus the banking sector is like a formula 1 engine. If it doesn’t break sometime, it means you are not squeezing all the performance you could.”

    I’d much prefer the Canadian system, which has never broken.

    I never argued GSEs distorted the market, I argued they made (or purchased) many bad loans that shouldn’t have been made. I think the housing boom was a separate issue, weren’t most of the bad loans refis?

    You said;

    “I do worry, but worrying has a cost. I spend time worrying where to deposit my money rather than analyzing which investments to make.”

    Those are exactly the same worries! Banks are just intermediaries–we can’t give them a blank check to gamble where ever they wish.

    flow5, I agree that NGDP targeting would reduce the abuse of FDIC, but it would still need reform.

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