Reason.tv: Jeffrey Miron on The Financial Crisis and The Case For Doing Nothing

Nick Gillespie | April 27, 2009

During Reason Weekend, the annual event held by the nonprofit that publishes this website, Harvard economist and Reason contributor Jeffrey A. Miron argued that last year's bailout was a mistake and that any stimulus spending should consist of reductions in taxes, not increases in expenditures.

Miron is a senior lecturer and director of undergraduated studies at Harvard. Educated at Swarthmore and M.I.T., he has held positions at the University of Michigan and Boston University and he has written widely on the "economics of libertarianism," including a controversial and widely discussed cost-benefit analysis of the war on drugs that concluded prohibition's costs far outweigh any possible benefits.

Go here for podcast version. And go here for an iPod-friendly version.

Approximately 30 minutes. Shot and edited by Roger M. Richards.

Comments

JW Gacy|4.27.09 @ 3:39PM|#

Why is he doing an impression of Bjorn Lomberg?

High Every Body|4.27.09 @ 4:12PM|#

Any NYC Cosmotarians get scared by the air show today?

|4.27.09 @ 4:31PM|#

Heads up ... GM is proposing that government take majority ownership of the company.

http://news.yahoo.com/s/ap/20090427/ap_on_bi_ge/us_gm_plan

GM said that it will ask the government to take more than 50 percent of its common stock in exchange for canceling half the government loans to the company as of June 1. The swap would cancel about $10 billion in government debt.

In other words, the taxpayers never get their money back, and we end up with a state-owned car company.

JP|4.27.09 @ 4:36PM|#

In other words, the taxpayers never get their money back, and we end up with a state-owned car company.

And their first new model should be ... the Obamobile!

Paul|4.27.09 @ 4:45PM|#

But doing something means saving the lives of millions of registered voters...

|4.27.09 @ 5:11PM|#

GM said that it will ask the government to take more than 50 percent of its common stock in exchange for canceling half the government loans to the company as of June 1. The swap would cancel about $10 billion in government debt.

Seeing as GM's total market cap is less than $10 billion, this would be an utter ripoff of the taxpayer.

Tony-bot|4.27.09 @ 5:25PM|#

But something must be done. Obama said so.

BlueBook|4.27.09 @ 6:51PM|#

These speeches are interesting, but when are we going to get another episode of the Reason talk show?

The Thin Orange Line of Death|4.27.09 @ 7:42PM|#

Forget that, BlueBook: When is Reason going to ask politicians relevant questions on camera and post the responses on YouTube.

|4.28.09 @ 1:50AM|#

Is it just me or does this guy remind anyone else of Steve Martin?

Good stuff though.

Chad|4.28.09 @ 8:41AM|#

A conservative calls for tax cuts! Hold the presses!

Oh wait, do newspaper still exist anymore?

|4.28.09 @ 9:02AM|#

>Is it just me or does this guy remind anyone else of Steve Martin?

More like Steve Forbes.
Thanks for the 30 minutes of zombie-like lumbering and stammering, "Tax cuts, tax cuts".
Put down the bong, put down your tattered "Atlas Shrugged" paperback, stop giving fact-free, information-free speeches like this and do some useful work, like digging ditches.

|4.28.09 @ 11:50AM|#

Tax cuts don't stimulate anything except the prostate glands of wingnuts who don't know shit about anything, let alone how to end a recession.

Billy|4.29.09 @ 9:24AM|#

"Tax cuts don't stimulate anything..."

Perhaps not, but spending isn't going to increase demand much until people can somehow make up for the trillions of lost housing wealth... tax cuts can help with this at least

Typo alert|4.29.09 @ 1:24PM|#

It should read "director of undergraduate studies", not "undergraduated"

Cliff|4.29.09 @ 4:15PM|#

"Tax cuts don't stimulate anything..."

It must be tough to ignore so much history, simply skip it and ignore it because it doesn't jive with your personal belief. Tax cuts have been tried on several occasions and result in dramatic stimulus, if you're willing to face the truth.

Most of you haven't lived at a time and place with hyper-inflation. I have. But I suspect that soon you will experience it first hand.

CKDH|4.29.09 @ 9:12PM|#

Very well done.

Somebody had to give a clear picture of what has happened and what happens now such as, redistribution to democratic institutions and not necessarily to the poor, etc.

Well, done Jeffrey Miron.

Thomas Aquinum|5.3.09 @ 6:27AM|#

Not the End of the World

I have been thinking a great deal about money, banking, credit and gold since the near collapse of the world's financial system during the week of September 15, 2008.
I have scoured the Internet for articles on this subject. Economics books don't help much. I am not satisfied with their explanations. However, I believe I have nailed the main issue that needs to be understood. The following are some thoughts and observations.

Paper Money and Loaves of Bread

Gold bugs (by which I mean, people who push gold as a medium of common exchange or money) are only partially right. They say world civilization will revert to gold and silver as money when paper money and bank deposits become worthless due to rampant hyperinflation, after a worldwide Weimar Republic type scenario. This assumes that there will be a complete mistrust of governments and the banking industry.

Even if this unlikely scenario (world wide hyper-inflation) occurs, I believe paper money and bank deposit money will not be abandoned. The benefits of paper money and modern banking are just too great. Gold and silver based money requires physical possession, storage, safekeeping services, and transport for exchange in economic transactions (i.e., for making purchases or payment of bills). Note that there have been hundreds of currencies that have failed due to hyper-inflationary money creation (via both the printing of money and bank-deposit money creation), but this has not meant that people have stopped seeing the value of a paper money system and bank-deposit based economy.

People know from the collective experience of the last few hundred years (remember, the pound sterling is 317 years old), that when managed properly, this type of economic organization is superior to carrying around gold and silver. If a worldwide Weimar event does come to pass it will not be the end of paper money and bank deposit money. We will just have a fresh start with a new currency, much like what Germany did after the Weimar hyperinflation. (Sorry gold bugs and survivalists, we won't all be shooting at each other, and gold will go up but only in terms of hyper-inflated money, not much in terms of loaves of bread).

Money Creation

At this point, the world civilization has sufficient understanding that too much money creation can lead to hyperinflation and make a currency worthless. Note that in modern economies, most money creation is done by the banking system through the process of fractional reserve banking.
Fractional reserve banking is just another way of saying that cash initially created by the government is lent and re-lent many times over (i.e., lent, deposited, re-lent, deposited again, and so on). So the initial cash created is multiplied by the banking system. The economy "acts" like there is more cash than what was originally created by the government, because bank deposits can be used to pay for purchases or to pay bills just like paper cash. The amount of money thus "created" is only limited by the banking industry's willingness and ability to find credit-worthy borrowers.
Note that it is NOT the government creating the money most of the time; it is the banking system doing it. United States Government-issued paper cash is only 3% of the world's dollar supply, and its electronic equivalent, the central bank dollar reserves at the FED (sometimes also called "base money" or "high-powered money") are probably not much more, in percentage terms.

Collateral Damage

So what is the problem? The problem is that the world is finding out that Adam Smith needs to be updated. Economists know that Capitalism works well because the punishment of the marketplace is allowed to destroy bad actors (a la Lehman Brothers). Henry Paulsen and Ben Bernanke tell us that Lehman Bankruptcy started a chain reaction where there was so much mistrust between counter-parties of the major financial institutions that inter-bank lending and other lending "seized up" (almost stopped). If that had been allowed to continue we probably would have had extreme deflation very fast (at the speed of the internet).
Deflation will occur if bank deposits are destroyed. Remember--each commercial bank, savings and loan, credit union or even money market mutual fund that fails would have reduced the total bank deposits in the banking system. Failure of a depository institution means that its deposits cannot be used to make purchases, or pay bills, by depositors of those institutions (i.e., businesses and individuals). Defaults lead to cross-defaults (party B defaults because its counter-party A has defaulted). Cross-defaults on a massive scale, where a money center bank like Citibank is involved, would have led to massive bankruptcies and widespread bank runs.
Therefore, in order to punish bad actors we would have to inflict tremendous amount of collateral damage on innocent bystanders. The Great Depression of the 1930s comes to mind. Adam Smith's invisible hand works, but sometimes the collateral damage is enormously large.

Is There a Better Way?

World War II was a pivotal event in human history. It did so much collateral damage that near the end of the war, world powers were convinced that all-out total "hot" war was no longer an option, given the current technology. Therefore, world powers started fighting more "cold" than "hot" wars (Roman and Persian Empires probably fought more "hot" than "cold"). The USA and USSR fought mostly "cold," with some small "hot" proxy wars.
The rules of all-out war broke down in the face of massive weaponry. The superpowers adjusted to the new reality.

Newton's laws break down near the speed of light. Einstein updated them.

Where am I going with all this? Today's world economy, where most of the world's money supply (i.e., stuff used to pay bills and make purchases) is in the form of bank deposits residing in mega-institutions, can suddenly and violently contract if the invisible hand is allowed to dole out punishment in the traditional way to bad actors (in this case, poorly managed large financial institutions). So the trillion-dollar question is... how should Adam Smith be updated?

I will discuss this next time.

http://aquinums-razor.blogspot.com/

Money, Banking, Credit and Gold II

This is a continuation of the earlier essay: Money, Banking, Credit and Gold. In part II I would like to elaborate why I think the resolution to a major banking crises such as the one we are now going through should not be left completely to the market.

Joint Projects - Private Industry and Government

Our currency (and the banking industry) is in reality a joint project between our government (creates physical paper cash money and its electronic equivalent central bank reserves) and the private sector (creates bank deposit money by leveraging the government created money). Many major projects work this way in our vast and highly complex civilization. The airline industry is supported by 50,000 employee government agency (the FAA). The pharmaceutical industry is supported by 9,000 employee government agency (the FDA). The maritime industry is supported by tens of thousands of government employees at the United States Coast Guard and United States Merchant Marine. Various federal and state agencies manage and maintain our federal and state highways. Existence of and proper maintenance of our federal and state highways make our automobiles much more useful. State and local governments provide us with most of our elementary, middle, high school education and a major part of college and post-graduate education. Here is the point: Adam Smith suggested that the government should do no more than defense, administration of police, courts and jails.

You see we have already gone far beyond what Adam Smith had recommended. Why? Because our experience has shown that these government institutions (FAA, FDA, Coast Guard, United States Merchant Marine, Federal and State highway and road administration departments, public school system, public college system) CAN produce far more good than the costs associated to them.

In "Part I" I suggested that leaving resolution of banking crises to the market is like allowing nuclear bombs to explode all over the country (and maybe all over the industrialized world) in order to punish bad management in the banking industry. I suggested that defaults and cross-defaults and bank runs would lead to a nuclear fission like chain reaction causing massive bankruptcies and a huge sudden and violent contraction in the money supply and probably deep double digit unemployment rate (unemployment rate during the great depression was 25%, except now it would probably occur at the speed of internet time). This would be Adam Smith's way of punishing bad behavior by the banking industry. This road involves tremendous amount of collatoral damage (this is how World War II was fought). I am suggesting we fight cold (similar to the way USA and USSR fought during the "cold" war. I will now relate this to banking industry. Consider the following:

Devil is in the details

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has weaned the public off physical paper money. Note that most money (about 90%) now sits as ledger entries on bank ledgers backed by loans (debt). Physical paper money is like having equity in the economic output of United States of America and has no credit risk associated to it. Physical paper money is not anyone's liability. Bank deposit money does have credit risk associated to it. It is the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than theft and physical loss risk of physical paper money. That is why we use bank deposit money more than physical paper money. Through this (normally) transparent process of inter-bank lending the banking system is acting like a giant clearinghouse (essentially a giant ledger) which clears payments between its customers without physical transfer of cash and keeps track of who has how much money. Note that most money in the world economy is not physical (paper cash or gold) but logical (ledger entries). Also, physical money is equity. Bank deposit money is backed by debt (actually not 100% true, reserves at the federal reserve system are also equity, essentially electronic version of physical paper cash). That difference: paper money = equity in USA economy and bank deposit = debt (meaning bank obligation) causes great confusion.

· You see we have become very comfortable with bank deposit money without thinking much about the credit risk we are taking. Bank failures create confusion and chaos because vast majority of businesses and individuals use banks for convenience (they can write checks rather than handling physical paper cash) and don't really want to take or think much about the credit risk normally associated with keeping their money (their most liquid capital) at the bank.

· The process of modern banking has monetized bank loans. Think of bank loans as a valuable commodity. A little bit like gold or oil. Of course, you have to worry about the quality of the bank loans (as you would have to worry about the quality of gold or oil). It is more difficult to assess the quality of bank loans and mortgages but the idea is the same. In the current crises we have around (in very rough numbers) $10 trillion of bank deposits backed by about $10 trillion of loans at book value (value currently being carried on banks books). But the book value of bank loans is off course with what will actually be realized (on a discounted basis) from these loans due to the expected rate of defaults. But certainly it is not zero (perhaps it is off by 30% to 40% at most). My point is this: A total meltdown of the financial system is like un-monetizing this $10 trillion of bank deposit money to zero at the speed of light (due to widespread bank runs if a very large commercial bank like Citibank fails and amount of leverage currently in the system this would probably occur in a matter of few weeks). This will cause way too much collatoral damage to our civilization. Imagine, if a thousand years ago 90% of gold disappeared, just vanished, in a matter of few weeks. Prices would then have to adjust to reflect the new scarcity of gold (that is, go down by approximately 90% in a matter of weeks).

· One of the things money and prices do is to help us compare relative values of goods and services. It helps us to see that a gallon of milk is worth two loaves of bread for example. Money and prices also help us plan for the future so we can enter into contracts and conduct business. A sudden huge money supply contraction will throw our economic relationships off balance and create chaos. Debtors will be especially hurt as they will have to pay back in much more expensive dollars or default (the debt burden during the great depression increased by 40% in real terms due to extreme deflation).


Banking Industry's Contribution to Society

· Lets consider what the banking industry does for the public. There are three major services a bank provides:

1. It provides a "safe" place to hold public's most liquid assets (cash).
2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).
3. It is a source of loan money (banks evaluate credit worthiness of potential borrowers). Think of this "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they end will up mis-allocating economic resources.

· Note that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk. If banks gave people a choice of 100% reserve accounts. These accounts would have no credit risk. There would still be fraud risk. A bank in desperation for cash could "dip" into the reserves allocated to the 100% reserve accounts. Of course we would make such "dipping" illegal.

· I believe the public (individuals and businesses) should have a choice of 100% reserve accounts that would have no credit risk (like physical paper cash) but does have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, such an account would not earn interest but will most likely have monthly maintenance fees associated to it (essentially an electronic version of a safe deposit box for physical paper cash and would be very much like reserve accounts banks have with the FED). Such accounts if widely used would lessen the impact of bank failures on the economy in terms of contraction of the money supply but would not completely eliminate them. More on this later.

· Lending involves business risks (credit risks). If a customer chooses a non-100% reserve account then they would be subject to losing their money. This forces the public to do some homework before handing money over to a bank (review its credit rating essentially). Of course in this type of setup a non-100% reserve account would probably have to pay a higher return then the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve account there would be no need to impose legal reserve requirements on non-100% reserve accounts.

· There would be clear separation of accounts that have credit risk and accounts that don't have a credit risk associated to them. The accounts with credit risk can set the interest rate high enough to attract depositors.

· Also, it would be better for commercial banks to not only give customers a choice of 100% reserve accounts (with no credit risk) but all accounts with credit risk associated to them should be setup like non-FDIC insured money market mutual funds. Non-FDIC insured money market mutual funds usually maintain a share price of $1 dollar but do not guarantee it. If a bank gets into trouble it can then simply "break the buck" as a quick resolution to insolvency. Breaking the buck means to set the share price to something less than $1 which would make the bank solvent again. Such a resolution reduces chaos and uncertainty and resolves insolvency quickly without requiring slow and expensive bankruptcy proceedings or expensive FDIC resolutions. Even after breaking the buck chances are the bank will be over-whelmed by withdrawal requests (due to fear of more write-downs and general uncertainty). The government can then arrange a takeover by a healthier bank and it can also limit the losses to the depositors (maybe to something like 25% maximum). The idea is to give enough punishment to depositors of the non-100% reserve account holders so they will evaluate a bank management's ability to take good risks before handing money over to them. I can see Moody's, S&P, Fitch and AM Best like rating agencies providing this service. Notice that I am still proposing that a large portion of (something like 75%) of depositor's money be bailed out (losses socialized). Why?

Money and Moneyness

· You see even the non-100% reserve account would become part of the money supply. Because as long as I can move my money back and forth between the proposed 100% reserve account (no interest paid) to savings accounts to money market accounts to CDs with ease it should be part of the money supply. Economy will "behave" such that all these are forms of money. 100% reserve accounts, savings accounts, money market accounts and CDs would be part of the money supply since they can all be used to pay bills and make purchases either directly or indirectly. Even T-Bills, bonds and stocks and even real estate have some moneyness to them. The harder the asset is to convert to a loaf of bread (due to transaction costs and volatility) the less its moneyness characteristic. The easier an asset is to convert to a loaf of bread the greater its liquidity and moneyness. E-bay and Craig List even give your furniture in your living room a moneyness characteristic by making them more liquid.

· More Later

|5.4.09 @ 9:33PM|#

Man, does Miron hit it on the head point after point. How could someone so brilliant and logical escape the realm of politics? Oh yeah, he's brilliant and logical.