Simon Johnson: Ron Paul And The Banks

This is from Simon Johnson’s blog. It is an interesting think-piece that, (1) takes Ron Paul seriously, and (2) criticizes Paul for his adherence to absolute free market banking by eliminating the Fed. I disagree with Professor Johnson’s interpretation of the causes of our banking crises and the rise of big banks.

I challenge my readers to write a rejoinder to Professor Johnson’s belief that a free market in banking using the gold standard would still result in Too Big To Fail banks and an unstable banking system. Any takers?

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Baseline Scenario: Ron Paul And The Banks

January 7, 2012

By Simon Johnson

 MIT Sloan School

We should take Ron Paul seriously. The Texas Congressman had an impressive showing in the Iowa caucuses on Tuesday and his poll numbers elsewhere are resilient – he is running a strong third nationallybut looks like to come in second in New Hampshire.  He may well become the Republican politician with populist momentum and energy in the weeks ahead.

Mr. Paul also has a clearly articulated view on the American banking system, laid out forcefully in his 2009 book, End the Fed.  This book and its bottom line recommendation that we should return to the gold standard – and abolish the Federal Reserve system – tends to be dismissed out of hand by many.  That’s a mistake, because Mr. Paul makes many sensible and well-informed points.

But there is a curious disconnect between his diagnosis and his proposed cure.  This disconnect tells us a great deal about why this version of populism from the right is unlikely to make much progress in its current form.

There is much that is thoughtful in Mr. Paul’s book, including statements like this (p. 18):

“Just so that we are clear: the modern system of money and banking is not a free-market system.  It is a system that is half socialized – propped up by the government – and one that could never be sustained as it is in a clean market environment.”

Mr. Paul is also broadly correct that the Federal Reserve has become, in part, a key mechanism through which large banks are rescued from their own folly – so that their management gets the upside when things go well and the realization of any downside risks gets shoved onto other people.

If you don’t like this characterization of the American system, turn your attention to Europe and the eurozone – where the European Central Bank is busy propping up banks with “liquidity” (in the form of three year loans), in part hoping these financial institutions can in turn support the government bond market.

There are no Ron Paul-type populists in Europe – at least I have never come across a mainstream politician there wanting to abolish any central bank.  But I would predict that related views will pick up European adherents in the months ahead, for example as people in Germany increasingly worry about the actions of the European Central Bank – and want to go back to some version of their own Bundesbank, which was very careful about not creating inflation.

Mr. Paul represents an important strand of American libertarian thinking, seeing the root of all financial evil in the role of the government – and tracing this back to what he sees as deviations from the U.S. Constitution, made possible by the Supreme Court (beginning with McCulloch v. Maryland in 1819; I recommend Aggressive Nationalism: McCulloch v. Maryland and the Foundation of Federal Authority in the Young Republic, by Richard E. Ellis, if you’d like to read more on that key episode).

Mr. Paul’s argument goes too far in this direction, however, including with statements like “The Supreme Court has never been a friend of sound money and has rarely been a protector of the Constitution,” (p.168).  His book would also be more convincing if it relied a little less exclusively on sources produced by a single publisher, the Ludwig von Mises Institute.

The gold standard to Mr. Paul is a panacea, because it would restrict the role of the government and what a central bank could do.  In fact, in his version of the gold standard – which is not the one that generally prevailed – there is no role for a central bank whatsoever.

But Mr. Paul’s own book also acknowledges the imbalance of power within the financial system that prevailed at the end of the nineteenth century – Wall Street financiers, such as the original J. P. Morgan, were among the most powerful Americans of their day.  In the crisis of 1907, it was Morgan who essentially decided which financial institution would be saved and who must go the wolves.

Would abolishing the Fed really create a paradise for entrepreneurial banking start-ups – enabling them to challenge and overthrow the megabanks?

Or would it just concentrate even more power in the hands of the largest financial players?  It is hard to find a moment of greater inequality of power than that of the gilded age of the late 1800s – with the gold standard and the associated credit system firmly working to the advantage of J. P. Morgan and his colleagues.

Mr. Paul insists that “In a competitive and free system, deposits would not be unsafe; any that were not paid back that were promised would fall under the laws of protection against fraud,” (p. 27).

Again, this seems to mistake the true nature of power in both modern American society – and in a world without any limit on the scale and nature of banks.  Laws and rules do not drop from the sky; they are shaped in minute detail by an intense and very expensive lobbying process.  (For a prominent and credible example, Jeff Connaughton’s latest piece on how slow the SEC has been to deal with concerns about high frequency trading.)

There is nothing on Mr. Paul’s campaign website about breaking the size and power of the big banks that now predominate (  End the Fed is also frustratingly evasive on this issue.

Mr. Paul should address this issue head-on, for example by confronting the very specific and credible proposals made by Jon Huntsman – who would force the biggest banks to break themselves up.  The only way to restore the market is to compel the most powerful players to become smaller.

Ending the Fed – even if that were possible or desirable – would not end the problem of Too Big To Fail banks.  There are still many ways in which they could be saved.

The only way to credibly threaten not to bail them out is to insist that even the largest bank is not big enough to bring down the financial system.


7 comments to Simon Johnson: Ron Paul And The Banks

  • JR

    I’ll give it a go;

    Pre the Fed I believe the likes of JP Morgan were the Fed, as in the clearing house. It would be interesting to know whether the obligations of JP Morgan et al were freely redeemable in gold of a fixed weight & purity?

    If so, then it is impossible that JP Morgan et al was to big to fail, since their assets must have been of a quality so as to make liquidation impossible. Their size is irrelevant, I follow the ideas of Melchior Palyi here.

    If not, then the fact that JP Morgan et al are still a going concern 100 years later means that they have always been failures, mollycoddled by government, likely because of their ability to monetise government debt.

  • JR

    I might also add, as I commented several days ago, the 2008 ‘fiasco’, as Noug Noland eloquently put it, shows that the global financial system is hopelessly illiquid, since a liquid financial structure makes wholesale liquidation impossible.

    Ending the Fed & the global central banking ‘cartel’ is not going to be without pain for many, if not most, as the ‘assets’ of banks are found worthless. The government will not be able to inflate if there is no backstop & so no buyers for its debt. That said, the scam can’t go on forever, the bubble will burst & the larger it is blown the worse it will be.

  • Keith Weiner

    Simon needs to understand that when he says men are too to be allowed to be free, that this should then automatically rule out men ruling other men by force.

    Are central planners smarter or more efficient with other people’s money that they took by force? Are they more honest?

    Does the unseen not exist, or does it always amount to a smaller net negative than the seen positive?

  • Keith Weiner

    JR: indeed, it will be horribly painful; the longer we extend the more painful it will be.

  • killben

    See .. one way to reduce the TBTF disease is to increase the capital requirements.. for every stepped increments. For Say $x billion in asset–y% for every increment z, 2y%, 4y%, 8y%.

    Ending the Fed is one good idea anyway. Because if they exist they exist for only 2 reasons– bail out banks and prop up asset values. Do you really need these guys..

  • ohioralph

    I find Simon Johnson’s statement that sources for Ron Paul’s book is the Ludwig von Mises Institute. This is quite consistent since his views come from the Austrian School of which Mises is the principal proponent.

    Simon Johnson is Keynesian which influences his thinking as he demonstates throughout his article by advocating government intervention. It is very possible that Keynesian economic thinking is the theory that creates TBTF banks where Austrian economic thinking creates an atmosphere of market regulation which would would make TBTF highly unlikely.

  • Chris Goodwin

    Or try this one.

    What is the ratio of money to life ? (In insurance cases this often comes up. A kills B, O.K. it was an accident, but B leaves widow, orphans, etc. How much is A’s insurer on the hook for.) The issue is frequently seen as distasteful , macabre, but it has to be dealt with.

    Now take mega fraud, leading to losses of millions, billions, (soon trillions ?) Where these losses fall is not the issue, but some of it, at least, will hit the Revenue. So, ceteris paribus, budgets get screwed, – say 10 million less to defence, – 20 million less to highway maintenance, – 50 million less to housing – 100 million less to medicatastrophe, etc. All such trimmings of the budgets have consequences. Sub optimal body armour in foreign wars = so many extra body bags, so much in road maintenance cut = so much extra road kill, and so on. Of course, you cannot link a particular budget cut to a specific death – did the latest round of savings kill this marine here or that pilot there – but you get the idea. One million perhaps kills one tenth of an American. So ten million of lost tax revenue, if caused by criminal incompetence, negligence or fraud, should be automatically treated as a case of homicide. True, this rather leaves out Habeas Corpus, but since Magna Carta has got the chop, why not clean up on all these old fashinoned, old World, British imperialist burdens. Then any banksters who lose, say, six billion (where is the clients’ money ? How do you expect me to know ? – How about, because you were the boss, and it was your duty to know ?) – might reasonably expect to end up as lifers.

    There used to be a lot of left wing idiots who whined about monetary crime being treated more harshly than offences against the person. Perhaps they should realize that large scale fraud is murder – not a crime passionelle, just indifferent, cold blooded murder.

    That might get bankers to run a tighter ship. They could still earn good money.