Catastrophic Bank Failures Do Not Necessarily Promote Economic Activity

Dean Baker beats up on a line from the New York Times:

The NYT tells us that President Bush and Treasury Secretary Paulson are philosophically opposed to such restrictions, so presumably there must be someone who philosophically favors them, although the article does not identify anyone in this category. As a general rule, it is probably reasonable to assume that most people are philosophically opposed to regulations that they perceive to be harmful to the economy. The differences arise over which measures they perceive, or claim to perceive, as being harmful.

The context?

As Congress and the Bush administration struggle to contain the housing and credit crises — and prevent more Wall Street firms from collapsing as Bear Stearns did — a split is forming over how to strengthen oversight of financial institutions after decades of deregulation … One central battle is likely to be over tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses. The Democratic proposals would subject Wall Street firms to the kind of strict oversight that banks have had for decades … “You do it right, and it’s pro-market,” Mr. Frank said in an interview. “Right now, we have an investors’ strike going on, and restoring investor confidence is a top priority.” But industry groups warn that heavy-handed regulation could dry up investment capital just when the economy needs it most … But both President Bush and Mr. Paulson, a former chief executive of Goldman Sachs, remain philosophically opposed to restrictions and requirements that might hamper economic activity.

Congressmen Frank argues that we should step back from the laissez faire drive with respect to financial markets while the White House seems to be in favor of less regulation. Paul Krugman argues in the New York Times that less regulation is not necessarily pro-growth:

Contrary to popular belief, the stock market crash of 1929 wasn’t the defining moment of the Great Depression. What turned an ordinary recession into a civilization-threatening slump was the wave of bank runs that swept across America in 1930 and 1931. This banking crisis of the 1930s showed that unregulated, unsupervised financial markets can all too easily suffer catastrophic failure. As the decades passed, however, that lesson was forgotten — and now we’re relearning it, the hard way. To grasp the problem, you need to understand what banks do. Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment. Banks exist because they help reconcile the conflicting desires of savers and borrowers. Savers want freedom — access to their money on short notice. Borrowers want commitment: they don’t want to risk facing sudden demands for repayment. Normally, banks satisfy both desires: depositors have access to their funds whenever they want, yet most of the money placed in a bank’s care is used to make long-term loans. The reason this works is that withdrawals are usually more or less matched by new deposits, so that a bank only needs a modest cash reserve to make good on its promises. But sometimes — often based on nothing more than a rumor — banks face runs, in which many people try to withdraw their money at the same time. And a bank that faces a run by depositors, lacking the cash to meet their demands, may go bust even if the rumor was false. Worse yet, bank runs can be contagious. If depositors at one bank lose their money, depositors at other banks are likely to get nervous, too, setting off a chain reaction.

Paul is arguing that we have forgotten the lessons learned in the aftermath of the Great Depression. This happens to be a case where the reporters of a certain newspaper should be looking over at its oped pages for a little reminder of what the economic issue really is.

Update: Greg Mankiw seems to have an issue with what Paul wrote:

Let me remind everyone of one important difference: Deflation was a large part of the story of the 1930s, and that does not seem like a significant risk today.

Greg then goes onto to discuss the debt deflation hypothesis beginning with:

From 1929 to 1933 the price level fell 25 percent. Many economists blame this deflation for the severity of the Great Depression. They argue that the deflation may have turned what in 1931 was a typical economic downturn into an unprecedented period of high unemployment and depressed income. If correct, this argument gives new life to the money hypothesis. Because the falling money supply was, plausibly, responsible for the falling price level, it could have been responsible for the severity of the Depression. To evaluate this argument, we must discuss how changes in the price level affect income in the IS LM model.

I’m glad the Greg reminds us of this hypothesis given the tendency of some FDR critics to argue as if falling prices had only stabilizing effects. But falling prices are not an exogenous event in this ISLM model. In other words, some other event had to initiate the fall in aggregate demand that led to falling prices. The falling prices may have exacerbated the fall in real income but they did not cause it.

Finding “parallels between the current financial turmoil and what happened during the Great Depression” as Paul did does not mean that one is predicting another Great Depression.