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Wednesday, April 14, 2010

Can the Government Regulate Inflation?

The ominipotent State.

In a recent column, Nobel Prize winning economist Paul Krugman claimed that the government needs to have two important duties in finance. First, it must keep interest rates low; second, it must strictly regulate where the newly created money goes.

Now, as one who believes that government cannot simultaneously make water run downhill and uphill, I also believe that government lacks the proper tools to wildly inflate the currency and control the fallout. Unfortunately, the Great Minds of today think differently.

Writing about the high rate of bank failures in Georgia, compared to the relative stability in Texas, Krugman says that in most cases the high rates of foreclosures tended to be concentrated in areas with strict zoning laws:

To appreciate Georgia’s specialness, you need to realize that the housing bubble was a geographically uneven affair. Basically, prices rose sharply only where zoning restrictions and other factors limited the construction of new houses. In the rest of the country — what I once dubbed Flatland — permissive zoning and abundant land make it easy to increase the housing supply, a situation that prevented big price increases and therefore prevented a serious bubble.

Now, this would seem to be a case of the Law of Unintended Consequences rearing its head, but that seems to have escaped the Nobel laureate. Instead, Krugman claims that he has found the magic bullet that tells us why Texas did not have the same kind of banking crisis that hit Georgia:

It was fun while it lasted. Then the music stopped.
Why didn’t the same thing happen in Texas? The most likely answer, surprisingly, is that Texas had strong consumer-protection regulation. In particular, Texas law made it difficult for homeowners to treat their homes as piggybanks, extracting cash by increasing the size of their mortgages. Georgia lacked any similar protections (and the Bush administration blocked the state’s efforts to restrict subprime lending directly). And Georgia suffered from the difference.

So what’s the matter with Georgia? As I said, banks went wild, in a scene strongly reminiscent of the savings-and-loan excesses of the 1980s. High-flying bank executives aggressively expanded lending — and paid themselves lavishly — while relying heavily on “hot money” raised from outside investors rather than on their own depositors.

It is hard to examine this point in a short column, and I don’t know how much Georgia’s banking laws differ from those in Texas, although the ultimate irony to me is that George W. Bush was governor of Texas before coming to the White House, which, according to Krugman, generally makes that state evil. Nonetheless, I will take Krugman’s word for it that Texas has stricter banking regulations than does Georgia (although the devil always is in the details, and I suspect that the differences between Georgia and Texas are more cloudy than what Krugman tells us).

Thus Krugman, reasons, the key to financial reform is regulation: “[T]he contrast between Texas and Georgia suggests that consumer protection is an essential element of reform.”

Thus Krugman readily support policies of inflation and having the Federal Reserve artificially hold down interest rates. In other words, Krugman believes the government actively should push easy money.

However, he also wants government to determine who receives the new money through aggressive regulation. To put it another way, he wants the government simultaneously to make water flow downhill and uphill at the same time. That dog won’t hunt, people.

Krugman seems to be the last economist who does not understand the “capture theory of regulation,” the insight, established long ago in the formal and informal economics literature, that the regulated eventually come to dominate the regulators. Instead, Krugman wants us to believe that as long as the regulatory offices are filled with “smart and well-meaning” apostles of financial regulation, everything will be fine.

To put it another way, he believes that the same government (or at least a government run by experts like him) that turns on the inflation spigots also is so wise that it can tell us exactly where that inflation should be directed, thus bringing happiness and prosperity to all. I don’t think so.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.