Krugman vs. Goldman and Moral Hazard

By Jeff Harding

New York Times columnist and Nobel prize winning economist Paul Krugman says (“The Joys of Sachs”) that record profits are good for Goldman Sachs and bad for the country.

Professor Krugman’s view is that the economy has been “financialized” since the “deregulation” of the Reagan Administration. That is, more and more financial products were invented not for the benefit of the economy, but are just phony hyped-up financing gimmicks to enrich the pockets of investment bankers. We need stronger regulation.

The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. …

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers. …

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

This is such a mishmash of confused facts and simplistic ideology that it will take some effort to sort out what he is saying. Which leads me to conclude that he is just another polemicist not interested in finding any truth, at least in his articles where he is preaching to the choir (readers of the NYT). Let me explain.

What he is talking about is the concept of “moral hazard,” which in economic theory means that if you reward someone for bad behavior, they will do it again. This is especially relevant in government economic policy. It is being discussed, as we all know, with reference to the Bailout of financial institutions. Professor Krugman has a point here, but he goes at it completely wrong.

It is a fact that the Bailout of financial institutions created a moral hazard. The rescue of these so-called “too big to fail” institutions actually does reward them for taking risks, which, but for government policies, they wouldn’t have done. As I pointed out in several articles, what lender in their right mind would lend money to buy a home to a person with little down payment, no income records, no employment history, and a bad credit score?

I have discussed at length the roll of the government in actually creating an environment which allowed, encouraged, and subsidized these institutions to take huge risks in derivative securities. I do not spare the Wall Street financial community’s role in failing to evaluate the risk of these securities. But the crisis would not have occurred without the federal government’s various policies: FDIC deposit insurance, Fannie and Freddie lending policies and guarantees, political pressure, and the Fed’s easy money.

There is no institution that is too big to fail. It is easy to slip into the mindset that “we’ve got to do something” when there is a financial panic. But such policies are shortsighted and always yield consequences that are worse than the “cure.” One need only look to the Great Depression and Japan to see the “do something” policies go dangerously awry.

Back to Professor Krugman. He does make an excellent point. We are operating in a heads-Goldman-wins, tails-the-taxpayer-loses system. If a financial institution fails, even if it engages in the same risky behavior as before, it will be bailed out by the federal government. This is not an explicit promise, but there is a tacit understanding that if you’re “too big to fail” you will be bailed out by the government. This crisis has proved that point. So go ahead and roll the dice, get big profits and big fees and worry about it later.

I am aware of an economic system that eliminates moral hazard. It is called the free market: if you fail, you’re gone. No moral hazard there. The only reason we have the issue of moral hazard is because our government allows it. Instead of creating more bureaucracies employing legions of lawyers and accountants, eliminate the guarantees. Eliminate the policies that created the problem. If your bank wishes to engage in risky lending behavior, buy insurance to protect yourself; don’t come whining to the taxpayers for help. (Private insurance would be much cheaper.)

I know, I know, this view is extremely naive and impractical. We live in an enlightened world and the government and the Fed know what they are doing. A new Financial Services Risk Management Commission is just what we need to cure the problem.

If you believe that, then why, in light of the fact that the Wall Street players are among the most heavily regulated of all industries in America, did we end up in this mess? Trust me Paul, nothing will change.