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Archive for the ‘Financial Crisis’ Category

A few days ago, I shared some academic research investigating whether economic crises lead to more liberalization (Naomi Klein’s hypothesis) or more statism (Robert Higgs’ hypothesis).

Given the dismal long-run outlook for the United States and most other developed nations, this is not just a theoretical issue.

Well, the good news is that the evidence shows that economic turmoil appears to be associated with pro-market reforms. At least with regard to regulatory policy.

Today, I’m going to share more good news. We now have some empirical research from two Danish economists showing that voters like good policy.

Here’s what Niclas Berggren and Christian Bjørnskov wanted to ascertain in their research

Since the early 1980s a wave of liberalizing reforms has swept over the world. While the stated motivation for these reforms has usually been to increase economic efficiency, some critics have instead inferred ulterior motives…with the claim that many of the reforms have been undertaken during different crises so as to bypass potential opponents, suggests that people will dislike the reforms and even be less satisfied with democracy as such. We test this hypothesis empirically, using panel data from 30 European countries in the period 1993–2015. The dependent variable is the average satisfaction with democracy, while the reform measures are constructed as distinct changes in four policy areas: government size, the rule of law, openness and regulation. …We moreover include a set of control variables, capturing economic circumstances, political institutions and features of politics.

In other words, we’ve seen considerable liberalization over the past 20-plus years. Were voters happy or unhappy as a result?

Here’s a way of visualizing what they investigated.

For what it’s worth, I’ve argued that Reagan showed good policy is good politics.

And the good news is that this research reaches a similar conclusion. Here are their main results.

Our results indicate that while reforms of government size are not robustly related to satisfaction with democracy, reforms of the other three kinds are – and in a way that runs counter to the anti-liberalization claims. Reforms that reduce economic freedom are generally related to satisfaction with democracy in a negative way, while reforms that increase economic freedom are positively associated with satisfaction with democracy. Voters also react more negatively to left-wing governments introducing reforms that de-liberalize. …the hypothesis of a general negative reaction towards liberalizing reforms taking the form of reduced satisfaction with democracy does not stand up to empirical scrutiny, at least not in our European sample.

Wonky readers may want to spend some time with this table, which shows the results of the statistical analysis

I’ll close with a couple of specific observations from the research, all of which deal with whether some reforms are more popular than others.

The good news is that voters are most satisfied when there’s less protectionism.

It turns out that the most immediately important type of reform here is liberalizations that increase market openness, such as reductions in protectionism and removal of obstacles to capital movements.

(Methinks the folks in the White House may want to reconsider their protectionist policies. It seems people understand that trade wars cause blowback.)

The bad news is that voters don’t seem to get excited about reforms to restrain government spending, whereas other types of pro-market reforms are popular.

Reforms that involve government size are rarely statistically significant; reforms that involve the other three reform areas typically are.

Though voters sometimes aren’t happy when government gets bigger, so I guess that’s partial good news.

Crises only seem to matter when government size increases, and then they make the effect on satisfaction with democracy much more negative.

Perhaps this is evidence that people recognize Keynesian “stimulus” schemes aren’t a good idea? I hope that’s the right interpretation. Heck, maybe this is yet another reason to stop sending tax dollars to subsidize the OECD.

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When I give speeches about modern welfare states, I’ll often cite grim data from the IMF, BIS, and OECD about the very depressing fiscal consequences of ever-expanding government.

And if I really want to worry an audience, I’ll augment those numbers by talking about the erosion of societal capital and explain it’s very hard to adopt necessary reforms once the work ethic and self-reliance have been replaced by a culture of dependency and entitlement.

I basically warn people that many western nations (including the United States) are doomed to suffer Greek-style fiscal collapse. Depending on the type of speech, this is where I sometimes share a slide suggesting that there are two possible outcomes once an economic crisis occurs.

  • Does a crisis caused by bad government lead to even more bad government, which is the pessimistic hypothesis in Robert Higgs’ classic, Crisis and Leviathan?
  • Or does an economic crisis force politicians to actually scale back the size and scope of government, which is the hypothesis in Naomi Klein’s The Rise of Disaster Capitalism.

I’ve generally sided with Higgs, though there obviously are cases – such as Chile – where bad statist policies were followed by sweeping economic liberalization.

But, based on new research from the International Monetary Fund, it may be that Klein has a stronger argument (which would be a depressing outcome for her, since she favors bigger government).

Here are some of the issues that the authors investigated.

Relying on a new database of major past labor and product market reforms in advanced countries, we test a large set of variables for robust correlation with reform in each area. …structural reforms are notoriously difficult to implement…one of the most prominent hypotheses put forward in the literature, namely that crisis induces reform… we attempt to minimize value judgements and measurement error by employing a newly constructed “narrative” dataset of major reforms in four areas namely product market regulation (PMR) in network industries, EPL for regular workers, EPL for temporary workers, and unemployment benefit systems. … The large welfare costs of economic or financial crisis can break the deadlock over welfare-enhancing measures that could not be adopted otherwise due to conflict over their distributional consequences.

In short, they wanted to find out whether bad economic news (as captured by data on “GDP growth, deep recession, unemployment, crisis”) leads to pro-market reforms.

The answer is yes.

Our main result supports some form of the crisis-induces-reform hypothesis across all four reform areas. High unemployment, recession and/or an open economic crisis tend to be associated with a greater likelihood of reform. The effect is economically significant. For example, an increase of 10 percentage points in unemployment (as seen in several European economies in the aftermath of the Great Recession) is associated with an increase in the probability to undertake a major EPL reform for regular contract of about 5 percentage points — that is, about twice the average probability in the sample.

Here’s a chart from the report showing a big spike in deregulation in late 1990s/early 2000s.

And here’s a chart showing nations that took steps to cut back on unemployment subsidies.

Keep in mind, by the way, that some nations (such as Austria) may not have reformed because they never adopted bad policies in the first place.

Kudos to Denmark for implementing so much reform. And Greece wins a Booby Prize for failing to adopt desperately needed reforms.

I was also happy to see some results that bolster my argument in favor of jurisdictional competition as a tool to encourage better policy.

We also find evidence that outside pressure increases the likelihood of reform in certain areas. Reforms are more likely when other countries also undertake them.

Interestingly, it doesn’t appear that ideology plays a major role.

…we do not find any evidence for an ideological bias—there is no robust difference between left- and right-of-center governments’ propensity to undertake reform. …In the context of labor and product market reforms, while a reforming right-of-center government may face the combined resistance of the leftwing electorate, trade unions and other civil society groups, a left-of-center government will be less likely to be accused of pushing through reforms on ideological grounds and may therefore be more likely to succeed.

My two cents is that ideology can play a role (think Reagan and Thatcher, for instance), but that there are plenty of instances of putative right-of-center politicians making government bigger (Nixon and Bush, to cite US examples) and several instances of supposed left-of-center politicians overseeing pro-market reforms (Bill Clinton being the obvious example from America).

I’ll close with a very important caveat. The IMF study looked at regulatory policy. There are no lessons to be learned from this research about whether crises produce better fiscal policy.

For what it’s worth, based on all the post-financial-crisis tax increases that were imposed in Europe, I suspect that the Higgs hypothesis is still very relevant.

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The International Monetary Fund is a left-leaning bureaucracy that was set up to monitor the fixed-exchange-rate monetary system created after World War II.

Unsurprisingly, when that system broke down and the world shifted to floating exchange rates, the IMF didn’t go away. Instead, it created a new role for itself as self-styled guardian of economic stability.

Which is a bit of a joke since the international bureaucracy is most infamous for its relentless advocacy of higher taxes in economically stressed nations. So much so that I’ve labeled the IMF the Dr. Kevorkian of the world economy.

Or if that reference is a bit outdated for younger readers, let’s just say the IMF is the dumpster fire of international economics. Heck, if I was in Beijing, I would consider the bureaucracy’s recommendations for China an act of war.

To get an idea of the IMF’s ideological bias, let’s review it’s new report designed to discredit economic liberty (a.k.a., “neoliberalism” in the European sense or “classical liberalism” to Americans).

Here’s their definition.

The neoliberal agenda—a label used more by critics than by the architects of the policies— rests on two main planks. The first is increased competition—achieved through deregulation and the opening up of domestic markets, including financial markets, to foreign competition. The second is a smaller role for the state, achieved through privatization and limits on the ability of governments to run fiscal deficits and accumulate debt.

The authors describe the first plank accurately, but they mischaracterize the second plank.

At the risk of nitpicking, I would say “neoliberals” such as myself are much more direct than they imply. We want to achieve “a smaller role for the state” by reducing the burden of government spending.

Sure, we want to privatize government-controlled assets, but that’s mostly for reasons of economic efficiency rather than budgetary savings. And because we care about what actually works, we’re fans of spending caps rather than balanced budget rules.

But let’s set all that aside and get back to the report.

The IMF authors point out that governments have been moving in the right direction in recent decades.

There has been a strong and widespread global trend toward neoliberalism since the 1980s.

That sounds like good news.

And the report even includes a couple of graphs to show the trend toward free markets and limited government.

And the bureaucrats even concede that free markets and small government generate some good results.

There is much to cheer in the neoliberal agenda. The expansion of global trade has rescued millions from abject poverty. Foreign direct investment has often been a way to transfer technology and know-how to developing economies. Privatization of state-owned enterprises has in many instances led to more efficient provision of services and lowered the fiscal burden on governments.

But then the authors get to their real point. They don’t like unfettered capital flows and they don’t like so-called austerity.

However, there are aspects of the neoliberal agenda that have not delivered as expected. …removing restrictions on the movement of capital across a country’s borders (so-called capital account liberalization); and fiscal consolidation, sometimes called “austerity,” which is shorthand for policies to reduce fiscal deficits and debt levels.

Looking at these two aspects of neoliberalism, the IMF proposes “three disquieting conclusions.”

I’m much more worried about stagnation and poverty than I am about inequality, so part of the IMF’s analysis can be dismissed.

Indeed, based on the sloppiness of previous IMF work on inequality, one might be tempted to dismiss the entire report.

But let’s look at whether the authors have a point. Are there negative economic consequences for nations that allow open capital flows and/or impose budgetary restraint?

They argue that passive financial flows (indirect investment) can be destabilizing.

Some capital inflows, such as foreign direct investment—which may include a transfer of technology or human capital—do seem to boost long-term growth. But the impact of other flows—such as portfolio investment and banking and especially hot, or speculative, debt inflows—seem neither to boost growth nor allow the country to better share risks with its trading partners… Although growth benefits are uncertain, costs in terms of increased economic volatility and crisis frequency seem more evident. Since 1980, there have been about 150 episodes of surges in capital inflows in more than 50 emerging market economies…about 20 percent of the time, these episodes end in a financial crisis, and many of these crises are associated with large output declines… In addition to raising the odds of a crash, financial openness has distributional effects, appreciably raising inequality. …there is increased acceptance of controls to limit short-term debt flows that are viewed as likely to lead to—or compound—a financial crisis. While not the only tool available—exchange rate and financial policies can also help—capital controls are a viable, and sometimes the only, option when the source of an unsustainable credit boom is direct borrowing from abroad.

I certainly agree that there have been various crises in different nations, but I’m wondering whether the IMF is focusing on the symptoms rather than the underlying diseases.

What happened in the various nations, for instance, to trigger sudden capital flight? That seems to be a much more important question.

In some cases, such as Greece, the problem obviously isn’t capital flight. It’s the reckless spending by Greek politicians that created a fiscal crisis.

In other cases, such as Estonia, there was a bubble because of an overheated property market, and there’s no question the economy took a hit when that bubble popped.

But there’s a very strong case that Estonia’s open economy has generated plenty of strong growth over the years to compensate for that blip.

And it’s worth noting that criticisms of Estonia’s market-oriented policies often are based on grotesque inaccuracies, as was the case when Paul Krugman tried to blame the 2008 recession on spending cuts that occurred in 2009.

So I’m very skeptical of the IMF’s claim that capital controls are warranted. That’s the type of policy designed to insulate governments from the consequences of bad policy.

Now let’s shift to the fiscal policy issue. The IMF report correctly states that “Curbing the size of the state is another aspect of the neoliberal agenda.”

But the authors make a big (perhaps deliberate) mistake by then blaming neoliberals for adverse consequences associated with the “austerity” imposed by various governments.

Austerity policies not only generate substantial welfare costs due to supply-side channels, they also hurt demand—and thus worsen employment and unemployment. …in practice, episodes of fiscal consolidation have been followed, on average, by drops rather than by expansions in output. On average, a consolidation of 1 percent of GDP increases the long-term unemployment rate by 0.6 percentage point.

The problem with this analysis is that it doesn’t differentiate between tax increases and spending cuts.

And since much of the “austerity” is the former variety rather than the latter, especially in Europe, it borders on malicious for the IMF to blame neoliberals (who want less spending) for the economic consequences of IMF-endorsed policies (mostly higher taxes).

Especially since research from the European Central Bank and International Monetary Fund (!) show that spending restraint is the pro-growth way of dealing with a fiscal crisis.

Let’s now look at what the IMF authors suggest for future policy. More taxes and spending!

…policymakers should be more open to redistribution than they are. …And fiscal consolidation strategies—when they are needed—could be designed to minimize the adverse impact on low-income groups. But in some cases, the untoward distributional consequences will have to be remedied after they occur by using taxes and government spending to redistribute income. Fortunately, the fear that such policies will themselves necessarily hurt growth is unfounded.

Wow, the last couple of sentences are remarkable. The bureaucrats want readers to believe that a bigger fiscal burden of government won’t have any adverse consequences.

That’s a spectacular level of anti-empiricism. I guess they want us to believe that nations such as France are economically stronger economy than places such as Hong Kong.

Wow.

Last but not least, here’s a final excerpt that’s worth sharing just because of these two sentences.

IMF Managing Director Christine Lagarde said the institution believed that the U.S. Congress was right to raise the country’s debt ceiling “because the point is not to contract the economy by slashing spending brutally now as recovery is picking up.”  …Policymakers, and institutions like the IMF that advise them, must be guided not by faith, but by evidence of what has worked.

We’re supposed to believe the IMF is guided by evidence when the chief bureaucrat relies on Keynesian theory to make a dishonest argument. I wish that “slashing spending” was one of the options on the table when the debt limit was raised, but the fight was at the margins over how rapidly the burden of spending should climb.

But if Lagarde can make that argument with a straight face, I guess she deserves her massive tax-free compensation package.

P.S. Since IMF economists have concluded (two times!) that spending caps are the most effective fiscal rule, I really wonder whether the authors of the above study were being deliberately dishonest when they blamed advocates of lower spending for the negative impact of higher taxes.

P.P.S. I was greatly amused in 2014 when the IMF took two diametrically opposed positions on infrastructure spending in a three-month period.

P.P.P.S. The one silver lining to the dark cloud of the IMF is that the bureaucrats inadvertently generated some very powerful evidence against the VAT.

P.P.P.S. Let’s close with something positive. IMF researchers last year found that decentralized government works better.

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The debate over socialism shouldn’t even exist. Everywhere big government has been tried, it has failed.

And we have reams of evidence that free-market economies dramatically out-perform statist economies.

Yet the siren song of socialism still appeals to a subsection of the population, either because of naiveté or an unseemly lust to exercise power over others.

So let’s once again wade into this debate that shouldn’t be happening.

Writing for the Dallas Morning News, former Texas A&M economics professor Svetozar Pejovich explains that adding “democratic” to “socialism” doesn’t change anything. What really matters is that Sanders and his supporters want bigger government. And that never ends well.

Sanders’ policies…are…incompatible with the American tradition of self-responsibility, self-determination and limited government under a rule of law. …putting those premises into practice requires the acceptance of two institutions: the redistribution of income initiated and monitored by federal government, and the attenuation of private property rights.

And these policies don’t lead to good results, something that Professor Pejovich understands very well given that he was born in the former Yugoslavia.

Of course, the lunch is not free. The short-run consequence of redistributive policies is erosion of the link between performance and reward, which, in turn, reduces economic efficiency and the pie available for redistribution. The long-run cost is the transformation of the American culture of self-responsibility and self-determination into the culture of dependence on the state. …Sanders’ democratic socialism bribes people to voluntarily accept the erosion of private property rights…via laws and regulations. Those law and regulations (such as reducing the right of employers to fire workers at will, giving tenants rights at the expense of apartment owners, granting special privileges to some rent seeking groups, etc.) transfer some decision-making rights from owners to public decision makers, or non-owners. …In the end, the attenuation of private property rights impedes the flow of resources to higher-valued uses and reduces economic efficiency of the economy.

Allow me to augment Professor Pejovich’s analysis by elaborating on how these policies hurt the economy. The redistributionism doesn’t lead to immediate disaster, but it inevitably lures a larger share of the population into dependency over time and the higher taxes required to finance the growing welfare burden gradually erode incentives for work, saving, investment, and entrepreneurship. The combination of those factors slowly but surely dampens the economy’s growth. And as I’ve repeatedly explained, even small difference in growth have enormous long-run implications for a nation’s prosperity.

And there comes a point, particularly given modern demographics, that the system breaks down.

The erosion of property rights has a similar effect, largely by causing a reduction in both the level of investment and the quality of investment. And since every economic theory agrees that capital formation is a key to long-run growth, the net effect of “democratic socialism” it to further weaken potential growth.

What’s especially frustrating is that leftists then point to reduced growth rates as an argument for even bigger government.

I’m not joking. Robert Kuttner of the American Prospect argues that young people are attracted to Sanders because their economic outlook is so grim.

Bernie Sanders has…broad and enthusiastic support, especially among the young…voters who say they are attracted rather than repelled by Sanders’s embrace of socialism. …this is the stunted generation—young adults venturing into a world of work, loaded with student debt, unable to find stable jobs or decent careers.

I basically agree that the economic situation for young people is tepid, but I’m baffled that this is an argument for bigger government since the statist policies of both Bush and Obama deserve much of the blame for today’s sub-par economy.

In other words, we’re seeing Mitchell’s Law in action. Politicians have adopted bad policies that have led to stagnation and now they’re using the resulting economic malaise as an argument for even bigger government. And young people, who are among the biggest victims, are getting seduced.

I’m tempted to simply say young people are too stupid to be allowed to vote, but instead let’s take a serious look at why so many of them are misguided.

Christine Emba of the Washington Post has a column pointing out young people openly embrace socialism.

…it seems that socialism is cool. …socialism does seem to have become the political orientation du jour among voters of a certain (read: young) age. …A January YouGov poll asked respondents whether they had a “favorable or unfavorable” view of socialism and capitalism. While capitalism rated significantly higher overall, those younger than 30 gave socialism higher marks: Forty-three percent viewed it very or somewhat favorably, compared with only 32 percent for capitalism.

The problem is that both Ms. Emba and a lot of young people apparently believe the nonsense spouted by people like Robert Kuttner. They actually blame capitalism for the economic weakness caused by government intervention.

…simple economics have pushed a younger generation of voters to embrace what used to be a dirty word. The past 10 years – for many millennials, the formative years of adulthood – have eroded the credibility of economic [classical] liberalism. The financial crisis and recession weakened youths’ faith in markets… Yet they were also told that the solution to the these problems was more [classical] liberal capitalism. But those solutions haven’t delivered… Underemployment, excessive debt, out-of-reach health care and delayed life goals are young peoples’ defining concerns, and the traditional assumption – that free markets and limited state intervention lead to good outcomes – just doesn’t ring true to them.

Wow, it’s bad enough that people blame free markets for a government-caused financial crisis, but Ms. Emba (and perhaps others) think that we’ve tried capitalist “solutions” after the crisis.

What planet is she on? Can she identify one thing that Obama has done that would count as a free-market response to the financial crisis? The fake stimulus? Obamacare? Dodd-Frank?

By the way, she points out that young people presumably have no idea what socialism actually entails. They just want traditional welfare-state redistributionism.

…for many millennials, “socialism” is simply shorthand for “vaguely Scandinavian in the best way” – free health care, free education and subsidized child care, a state that supports its citizens rather than leaving them at the mercy of impersonal corporations bent on profit. …the socialism that most millennials want is simply a return to a more muscular form of traditional liberalism, one that would have felt right at home in the administration of FDR.

Given that President Roosevelt was either malicious or ignorant, and given that his policies lengthened and deepened the Great Depression, I’m not exactly encouraged that millennials merely want traditional liberal (as opposed to classical liberal) policies.

Though it’s worth noting (in a very depressing sense) that a lot of young people are embracing more totalitarian versions of socialism. Here are some brief excerpts from a longer article in Vox.

Jacobin has in the past five years become the leading intellectual voice of the American left, the most vibrant and relevant socialist publication in a very long time. …That’s an opportunity that Jacobin is seizing to great effect, even if Sanders isn’t far enough left for their taste. The Sanders campaign “could begin to legitimate the word ‘socialist,’ and spark a conversation around it, even if Sanders’s welfare-state socialism doesn’t go far enough,” Sunkara wrote earlier this year. …Jacobin…now boasts a print circulation of about 20,000 and has gained about 400 more subscribers a week since Bernie started his ascent in November. …even if Bernie fades, there’s still a constituency for socialist ideas — a fact that could turn out to be much more important than the Sanders campaign itself.

And they really, really mean socialism. With all its warts.

“It is unapologetic about its interests in political economy and Marxism…,” Brooklyn College professor Corey Robin, a longtime leftist writer who signed on early and is now a contributing editor at Jacobin, says. …any Jacobin editor would be the first to tell you, Sanders is a normal labor liberal, or at most a social democrat. He doesn’t go far enough. …What we really need, Sunkara insists, is democratic worker control of the means of production. …A number of Jacobin’s contributors are members of the International Socialist Organization (ISO), the largest Trotskyist group in North America. …Sunkara’s allegiances…lie with Democratic Socialists of America (DSA). …Frase recalls working with the Freedom Road Socialist Organization, a post-Maoist group, while in high school.

I’m not sure to be more amazed that some people really believe this evil nonsense or more worried that Jacobin may actually represent the future of the left in America.

Time for some good news.

My Cato colleague Emily Ekins writes that young people are not hopeless idiots, at least not all of them. Though she phrases her argument in a much nicer fashion in a column she wrote for the Washington Post.

She starts with grim polling data.

A national Reason-Rupe survey found that 53 percent of Americans under 30 have a favorable view of socialism compared with less than a third of those over 30. Moreover, Gallup has found that an astounding 69 percent of millennials say they’d be willing to vote for a “socialist” candidate for president — among their parents’ generation, only a third would do so.

But she notes that for the most part they don’t actually believe in real socialism.

…millennials tend to reject the actual definition of socialism — government ownership of the means of production, or government running businesses. Only 32 percent of millennials favor “an economy managed by the government,” while, similar to older generations, 64 percent prefer a free-market economy. …what does socialism actually mean to millennials? Scandinavia. …In contrast with the 1960s and ’70s, college students today are not debating whether we should adopt the Soviet or Maoist command-and-control regimes that devastated economies and killed millions.

In other words, the nutjobs at Jacobin are still a minority on the left.

Best of all, young people are capable of learning lessons from the real world.

…as millennials age and begin to earn more, their socialistic ideals seem to slip away. …millennials become averse to social welfare spending if they foot the bill. As they reach the threshold of earning $40,000 to $60,000 a year, the majority of millennials come to oppose income redistribution, including raising taxes to increase financial assistance to the poor. …When tax rates are not explicit, millennials say they’d prefer larger government offering more services (54 percent) to smaller government offering fewer services (43 percent). However when larger government offering more services is described as requiring high taxes, support flips and 57 percent of millennials opt for smaller government with fewer services and low taxes, while 41 percent prefer large government.

And she explains that previous generations also have shifted away from big government.

In the 1980s, the same share (52 percent) of baby boomers also supported bigger government, and so did Generation Xers (53 percent) in the 1990s. Yet, both baby boomers and Gen Xers grew more skeptical of government over time and by about the same magnitude. Today, only 25 percent of boomers and 37 percent of Gen Xers continue to favor larger government.

My two cents, for what it’s worth, is that the infatuation with socialism (however defined) among the young underscores why it is so important to “win the narrative” about the causes of the financial crisis and the resulting weak economy.

To the extent that voters actually think capitalism caused the mess in 2008, they will be susceptible to statist ideologies.

In some sense, this is history repeating itself. The Great Depression largely was caused by misguided policies from Hoover and Roosevelt. Yet the left very cleverly peddled the story that capitalism had failed. As a result, generations of voters were more sympathetic to big government.

Thank goodness there are places such as the Cato Institute that are working to correct the narrative, not only about the Great Depression, but also with regards to the financial crisis.

Let’s close with a clever description of the difference between various strains of statism.

I put forth a similar analysis back in 2014, but I confess it wasn’t as clever as the above image. Or as clever as the sign I recently shared.

And let’s not forget the famous two-cow explanation of various ideologies.

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Politicians specialize in bad policy, but they go overboard during election years.

It’s especially galling to hear Bernie Sanders and Hillary Clinton compete to see who can make the most inane comments about the financial sector.

This is why I felt compelled last month to explain why the recent financial crisis had nothing to do with the absence of “Glass-Steagall” regulations.

Today, I want to address Dodd-Frank, the legislation that was imposed immediately after the crisis by President Obama and the Democrat-controlled Congress.

I’m tempted to focus on the fact that the big boys on Wall Street, such as Goldman-Sachs, supported the law. It’s galling, after all, to hear politicians claim Dodd-Frank was anti-Wall Street legislation.

But there are more important points to consider, including the fact that the law doesn’t prevent or preclude bailouts.

Writing for today’s Wall Street Journal, Emily Kapur and John Taylor identify key problems with the Dodd-Frank bailout legislation.

Sen. Sanders and others on both sides of the aisle have a point. The 2010 Dodd-Frank financial law, which was supposed to end too big to fail, has not. Dodd-Frank gave the Federal Deposit Insurance Corp. authority to take over and oversee the reorganization of so-called systemically important financial institutions whose failure could pose a risk to the economy. But no one can be sure the FDIC will follow its resolution strategy… Neel Kashkari, now president of the Federal Reserve Bank of Minneapolis, says government officials are once again likely to bail out big banks and their creditors.

Most important, they propose a new Chapter 14 of the bankruptcy code so that insolvent institutions – regardless of their size – are liquidated.

The solution is not to break up the banks or turn them into public utilities. Instead, we should do what Dodd-Frank failed to do: Make big-bank failures feasible without tanking the economy by writing a process to do so into the bankruptcy code… Chapter 14 would impose losses on shareholders and creditors while preventing the collapse of one firm from spreading to others. …the court would convert the bank’s eligible long-term debt into equity, reorganizing the bankrupt bank’s balance sheet without restructuring its operations. …Other reforms, such as higher capital requirements, may yet be needed to reduce risk and lessen the chance of financial failure. But that is no reason to wait on bankruptcy reform. A bill along the lines of the chapter 14 that we advocate passed the House Judiciary Committee on Feb. 11. Two versions await action in the Senate. Let’s end too big to fail, once and for all.

Amen. When big institutions go under, shareholders and bondholders should be the ones to bear the costs, not taxpayers.

Unfortunately, unless a new Chapter 14 of the bankruptcy code is created, it’s quite likely that regulators and politicians will simply opt for more TARP-style bailouts if big firms get in trouble.

So Dodd-Frank didn’t really do the one thing that was necessary.

But it did do a lot of things that make the system more costly and clunky.

Hester Pierce of the Mercatus Center explains that Dodd-Frank expanded regulation based on the theory that regulators can understand and plan the financial sector.

Dodd-Frank—built on the premise that markets fail, but regulators do not—places great faith in regulators to identify and stop problems before they develop into a crisis. …Dodd-Frank, despite language to the contrary, keeps the door open for future bailouts. …Dodd-Frank includes many provisions that are not related to financial stability, but fails to deal with key problems made evident by the crisis. …Dodd-Frank’s drafters chose to leave many key decisions to regulators. The contours of systemic risk, for example, were left to regulators to define. Moreover, because the prevailing narrative of the crisis focused on market failure, Dodd-Frank expanded regulators’ authority to shape the financial system. In addition to their substantial rule-writing responsibilities, under Dodd-Frank regulators now play a central role in monitoring, planning, and managing the financial markets.

Most worrisome, Hester notes that Dodd-Frank has provisions that benefit the big firms and may make them more likely to get bailouts.

Dodd-Frank gives FSOC broad powers to designate nonbank financial institutions and financial market utilities (such as derivatives clearinghouses) systemically important. …Designated firms are likely to be perceived as the firms the government is likely to rescue… Dodd-Frank was supposed to mark the end of taxpayer bailouts of financial firms. This pledge is undermined in several ways by the statute’s other provisions and the regulatory-centric approach that cuts across the whole statute. …The pressure on regulators to conduct bailouts is likely to be particularly strong with respect to systemically important institutions. …Regulatory failure played an important role in the last crisis by concentrating resources in the housing sector, encouraging reliance on credit-rating agencies, and driving financial institutions to concentrate their holdings in mortgage-backed securities. Dodd-Frank gives regulators more authority and broad discretion to shape the financial sector and the firms operating within it. When the regulators fail at this ambitious mission, they will again face internal and external pressure to cover those failures with a taxpayer-funded bailout.

Two other Mercatus experts, Patrick McLaughlin and Oliver Sherouse, show that regulators were among the biggest beneficiaries of the law. The law has led to a massive explosion in red tape.

The statute, which itself was 848 pages long, directed dozens of regulatory agencies to revise or create new regulations addressing the financial system in the United States. Those agencies responded with hundreds of new rules that will govern financial markets, on a scale that vastly exceeds any previous regulation of financial markets, and dwarfs the regulations that accompanied all other legislation enacted during the Obama administration. …Dodd-Frank…is associated with more than five times as many new restrictions as any other law passed since January 2009, for a total of nearly 28,000 new restrictions. In fact, it is associated with more new restrictions than all other laws passed during the Obama administration put together.

Here’s a rather sobering chart from the report.

Amazingly, the red tape generated by Dodd-Frank is roughly equal to all the regulation generated by every other law that’s been imposed during the Obama years.

Including the notoriously Byzantine Obamacare legislation.

All these new rules actually create a competitive advantage for big financial institutions.

Peter Wallison of the American Enterprise Institute has a must-read study on how Dodd-Frank imposes disproportionately heavy costs on small banks and small businesses.

…the reason for the slow recovery is the Dodd-Frank Act, enacted in 2010, which placed heavy regulatory costs and new restrictive lending standards on small banks. This in turn reduced the ability of these banks to finance small businesses, particularly the start-up businesses which are the engine of employment and economic growth. Large businesses have not been subject to the same restrictions because they have access to the capital markets, and their growth has been in line with prior recoveries. …recoveries after financial crises tend to be sharper than other recoveries, not slower as some have suggested. It is likely that, without the repeal or substantial reform of Dodd-Frank, the U.S. economy will continue to grow only slowly into the future. ……whatever regulatory costs are imposed on banking organizations— whether they be $2 trillion banks like JPMorgan Chase, $50 billion banks or $50 million banks— the larger the bank the more easily it will be able to adjust to these costs.

What’s especially frustrating is that the law was imposed because of a fundamental misunderstanding of what caused the crisis.

…the incoming administration of Barack Obama and the Democratic supermajority in Congress blamed the crisis on insufficient regulation of the private financial sector. This narrative, although factually unsupported, gave rise to the Dodd-Frank Act, which imposed significant new regulation on the US financial system but did virtually nothing to reform the government policies that gave rise to the financial crisis. …In developing and adopting the Dodd-Frank Act, Congress and the administration did not appear to be concerned about placing additional regulatory costs on the financial system.

Here’s the bottom line. Regulation is no replacement for market discipline.

And bankruptcy needs to be part of that discipline. After all, capitalism without bankruptcy is like religion without hell.

P.S. To give you an idea of how unserious politicians are, the Dodd-Frank law didn’t end bailouts, but it did create new racial and sexual quotas. So I guess we can take comfort in the fact that the bureaucracy will reflect all of America the next time they rip off taxpayers.

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I try to avoid certain issues because they’re simply not that interesting. And I figure if they bore me – even though I’m a policy wonk, then they probably would be even more painful for everyone else.

But every so often, I feel compelled to address a topic simply because the alternative is to let the other side propagate destructive economic myths.

That’s why I’ve written about arcane topics such as depreciation and carried interest.

In this spirit, it’s now time to write about “Glass-Steagall,” which is the shorthand way of referring to the provision of the Banking Act of 1933 that imposed a separation between commercial banking and investment banking.

This regulatory barrier has been relaxed over the years, in part by the Financial Services Modernization Act of 1999 (often known as Gramm-Leach-Bliley).

Our friends on the left are big fans of Glass-Steagall. They think the law fixed a problem that helped cause the Great Depression and they think its partial repeal is one of the reasons for the recent financial crisis.

Bernie Sanders, for instance, has made Glass-Steagall reinstatement one of his big issues, probably in part because Hillary Clinton’s husband signed the 1999 law that eased that regulatory burden.

That may or may not be smart politics for Senator Sanders, but it is based on economic illiteracy. Let’s look at what the experts say.

Peter Wallison of the American Enterprise Institute, for instance, offers some very important insights about Glass-Steagall and the financial crisis.

The so-called “repeal” of Glass-Steagall in 1999…had absolutely nothing to do with the financial crisis. The 1999 changes in one sector of Glass-Steagall Act made only one change in existing law: it permitted affiliations between commercial banks and investment banks. But by the time of the 2008 crisis, none of the large investment banks (like Goldman Sachs, Morgan Stanley or Lehman Brothers) had affiliated with any of the large commercial banks (like Citi, JP Morgan Chase or Bank of America). Commercial banks and investment banks had remained fierce competitors with one another right up to the time of Lehman Brothers’ bankruptcy. The simplest way to think about the financial crisis is that the largest investment banks and commercial banks got into financial trouble by acquiring and holding risky mortgages or mortgage backed securities based on these risky loans. This was permitted for both of them before Glass-Steagall was “repealed,” and it was permitted afterward. In other words, if Glass-Steagall had never been touched by Congress in any way, the financial crisis would have unfolded exactly as it did in 2008.

Bingo.

If the leftists are right and the partial repeal of Glass-Steagall was bad and destabilizing, shouldn’t they be able to point to some real-world evidence? To any real-world evidence? To a shred of real-world evidence?

Megan McArdle, writing for Bloomberg, also is baffled by the anti-empirical emotionalism of the Glass-Steagall crowd.

…those intrepid souls who continue to fiercely agitate for the return of the Glass-Steagall financial regulations…have become a powerful force in the Democratic Party. …there is a small problem It’s very hard to think of the mechanism by which the repeal of this rule made any significant contribution to the meltdown. …The problems appeared first at Bear Stearns, and then Lehman Brothers, straight investment banks and lenders like Countrywide.

By the way, there’s a bipartisan consensus on this matter.

Catherine Rampell of the Washington Post certainly couldn’t be called a libertarian or conservative, yet she also is flummoxed by the fixation on Glass-Steagall.

the Glass-Steagall Act…’s become the left’s litmus test for whether a politician is “tough” on Wall Street. …But Glass-Steagall had nothing to do with the 2008 financial crisis. …If the repealed provisions of Glass-Steagall had still been on the books, almost none of the institutions at the epicenter of the crisis would have been covered by it. Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley were basically stand-alone investment banks. AIG was an insurance company. Fannie Mae and Freddie Mac were government-sponsored entities that bought and securitized mortgages. Washington Mutual was a traditional savings-and-loan. And so on. Glass-Steagall, or the lack thereof, is a red herring.

Steven Pearlstein of the Washington Post – another columnist who has never been accused of being in love with free markets – is similarly baffled. And for the same reasons. The facts simply don’t match the left-wing narrative.

Bear Stearns, Lehman Brothers and Merrill Lynch — three institutions at the heart of the crisis — were pure investment banks that had never crossed the old line into commercial banking. The same goes for Goldman Sachs, another favorite villain of the left. The infamous AIG? An insurance firm. New Century Financial? A real estate investment trust. No Glass-Steagall there. Two of the biggest banks that went under, Wachovia and Washington Mutual, got into trouble the old-fashioned way – largely by making risky loans to homeowners. Bank of America nearly met the same fate, not because it had bought an investment bank but because it had bought Countrywide Financial, a vanilla-variety mortgage lender. Meanwhile, J.P. Morgan and Wells Fargo — two large banks with big investment banking arms — resisted taking government capital and arguably could have weathered the crisis without it.

The inescapable conclusion is that Glass-Steagall had nothing to do with the financial crisis.

Instead, the main causes of the 2008 meltdown were bad government policies, such as easy-money from the Fed and corrupt housing subsidies from Fannie Mae and Freddie Mac.

But even if you’re a leftist and want to say that the crisis was caused by “greed,” the various institutions that got burned by “greed” were not giant investment bank/commercial bank conglomerates.

Let’s cover two more issues. First, my colleague Mark Calabria points out that one of the core beliefs of the left simply isn’t true. Commercial banking isn’t always a safe and boring line of business (which therefore has to be protected from the vagaries of investment banking).

…the bizarre implicit assumption behind Glass-Steagall: that somehow commercial banking is risk free.  Anyone ever hear of the savings-and-loan crisis of the late 1980s and early 1990s?  No investment banking angle there.  How about the 400+ small and medium banks that failed in the recent crisis? According to the FDIC, not one of them was brought down by proprietary trading.

Second, let’s dispel the notion that the Great Depression was caused by – or exacerbated by – the pre-Glass-Steagall mixing of commercial banking and investment banking.

Stephen Miller of the Mercatus Center debunks this myth.

The narrative justifying the Banking Act of 1933 always derived from myths that large securities dealing banks caused the banking crisis during the Great Depression. The myths hold that: (1) securities dealing banks were more unstable and contributed to the Great Depression, and (2) securities dealing banks pushed people to purchase what turned out to be low-quality assets that performed poorly during the Great Depression. However, both myths have been disproven. For instance, on the first myth, a 1986 Rutgers University study found that banks involved in securities dealing were less likely to fail. …none of the 5,000 banks that failed during the 1920s had securities dealing affiliates. From 1930 to 1933, more than 25 percent of all national banks failed, but the number of failures among those with securities dealing affiliates was less than 10 percent. On the second myth, …a 1994 study in the American Economic Review found evidence to the contrary — that the public understood this conflict of interest, which resulted in commercial banks that dealt securities prior to the Great Depression tending to underwrite high quality assets. These banks tended to do better during the Great Depression.

Oh, and by the way, the Great Depression wasn’t caused by deregulated markets. The real blame belongs to all the policy mistakes made by Herbert Hoover and Franklin Roosevelt.

So here’s the bottom line.

Glass-Steagall is a meaningless distraction, but restoration of that law nonetheless attracts support from know-nothings who have a religious-type belief that financial markets are intrinsically evil.

P.S. Financial markets are imperfect, of course, but they’re only evil when investors and institutions want private profits and socialized losses.

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Back in 2010, I described the “Butterfield Effect,” which is a term used to mock clueless journalists for being blind to the real story.

A former reporter for the New York Times, Fox Butterfield, became a bit of a laughingstock in the 1990s for publishing a series of articles addressing the supposed quandary of how crime rates could be falling during periods when prison populations were expanding. A number of critics sarcastically explained that crimes rates were falling because bad guys were behind bars and invented the term “Butterfield Effect” to describe the failure of leftists to put 2 + 2 together.

Here are some of my favorite examples, all of which presumably are caused by some combination of media bias and economic ignorance.

  • A newspaper article that was so blind to the Laffer Curve that it actually included a passage saying, “receipts are falling dramatically short of targets, even though taxes have increased.”
  • Another article was entitled, “Few Places to Hide as Taxes Trend Higher Worldwide,” because the reporter apparently was clueless that tax havens were attacked precisely so governments could raise tax burdens.
  • In another example of laughable Laffer Curve ignorance, the Washington Post had a story about tax revenues dropping in Detroit “despite some of the highest tax rates in the state.”
  • Likewise, another news report had a surprised tone when reporting on the fully predictable news that rich people reported more taxable income when their tax rates were lower.

Now we have a new example for our collection.

Here are some passages from a very strange economics report in the New York Times.

There are some problems that not even $10 trillion can solve. That gargantuan sum of money is what central banks around the world have spent in recent years as they have tried to stimulate their economies and fight financial crises. …But it has not been able to do away with days like Monday, when fear again coursed through global financial markets.

I’m tempted to immediately ask why the reporter assumed any problem might be solved by having governments spend $10 trillion, but let’s instead ask a more specific question. Why is there unease in financial markets?

The story actually provides the answer, but the reporter apparently isn’t aware that debt is part of the problem instead of the solution.

Stifling debt loads, for instance, continue to weigh on governments around the world. …high borrowing…by…governments…is also bogging down the globally significant economies of Brazil, Turkey, Italy and China.

So if borrowing and spending doesn’t solve anything, is an easy-money policy the right approach?

…central banks like the Federal Reserve and the European Central Bank have printed trillions of dollars and euros… Central banks can make debt less expensive by pushing down interest rates.

The story once again sort of provides the answer about the efficacy of monetary easing and artificially low interest rates.

…they cannot slash debt levels… In fact, lower interest rates can persuade some borrowers to take on more debt. “Rather than just reflecting the current weakness, low rates may in part have contributed to it by fueling costly financial booms and busts,” the Bank for International Settlements, an organization whose members are the world’s central banks, wrote in a recent analysis of the global economy.

This is remarkable. The reporter seems puzzled that deficit spending and easy money don’t help produce growth, even though the story includes information on how such policies retard growth. It must take willful blindness not to make this connection.

Indeed, the story in the New York Times originally was entitled, “Trillions Spent, but Crises like Greece’s Persist.”

Wow, what an example of upside-down analysis. A better title would have been “Crises like Greece’s Persist Because Trillions Spent.”

The reporter/editor/headline writer definitely deserve the Fox Butterfield prize.

Here’s another example from the story that reveals this intellectual inconsistency.

Debt in China has soared since the financial crisis of 2008, in part the result of government stimulus efforts. Yet the Chinese economy is growing much more slowly than it was, say, 10 years ago.

Hmmm…, maybe the Chinese economy is growing slower because of the so-called stimulus schemes.

At some point one might think people would make the connection between economic stagnation and bad policy. But journalists seem remarkably impervious to insight.

The Economist has a story that also starts with the assumption that Keynesian policies are good. It doesn’t explicitly acknowledge the downsides of debt and easy money, but it implicitly shows the shortcomings of that approach because the story focuses on how governments have less “fiscal space” to engage in another 2008-style orgy of Keynesian monetary and fiscal policy

The analysis is misguided, but the accompanying chart is useful since it shows which nations are probably most vulnerable to a fiscal crisis.

If you’re at the top of the chart, because you have oil like Norway, or because you’re semi-sensible like South Korea, Australia, and Switzerland, that’s a good sign. But if you’re a nation like Japan, Italy, Greece, and Portugal, it’s probably just a matter of time before the chickens of excessive spending come home to roost.

P.S. Related to the Fox Butterfield effect, I’ve also suggested that there should be “some sort of “Wrong Way Corrigan” Award for people like Drum who inadvertently help the cause of economic liberty.”

P.P.S. And in the same spirit, I’ve proposed an “own-goal effect” for “accidentally helping the other side.”

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