Krugman’s Mythology of U.S. Banking History

Do the banking panics of the late 19th century prove that a safe and sound financial system requires government oversight of banks? Paul Krugman (and most every pundit) seems to think so. In his New York Times column of May 13, he writes: “Current right-wing mythology has it that bad banking is always the result of government intervention, whether from the Federal Reserve or meddling liberals in Congress. In fact, however, Gilded Age America—a land with minimal government and no Fed—was subject to panics roughly once every six years.”

That volatility would seem like a slam dunk for Team Krugman—except for one thing: the banks of that era did, in fact, face onerous government regulations that weakened the safety and soundness of the financial system. Krugman has picked an example that undermines his case; the Nobel laureate in economics and celebrated commentator has misread U.S. banking history.

As Steven Horwitz notes at Coordination Problem, banks were not allowed to operate branches across state lines, and this prohibition of interstate banking hindered their ability to diversify their portfolios and made them prone to panics. Moreover, federally chartered banks were required to back their currency with government bonds; this regulation made it too costly for them to respond to increases in the demand for money by issuing more bank notes, which in turn led to currency shortages and financial crises, such as the disastrous Panic of 1907.

Horwitz continues:

But Krugman has a much bigger puzzle to explain away: if free markets in banking are the problem, why did Canada, which, during this period, had a far less regulated banking system than the US, not experience the panics we did, and why did no Canadian banks fail during the Great Depression while around 9000 US banks did? If Krugman’s criticism of the “mythology” is correct, the Canadian banking system of that era should have been a basket case, but instead it was a model for the world precisely because it lacked the two most damaging government regulations present in the US. Canadian banks have always been free to operate nationwide and were, before 1934, able to issue their own currency free of bond collateral requirements. The very free market in Canadian banking dramatically out-performed the much more regulated US system.

So Professor Krugman, what say you? If the reason banks fail is because free markets in banking don’t work, how do you explain the lack of the problems you claim plague free markets in the much less regulated pre-1934 Canadian banking industry?  The mythology, Professor, is your history, not mine.

Well said.

Carl Close is Research Fellow and Senior Editor for The Independent Institute and Assistant Editor of The Independent Review and editor of The Lighthouse, The Independent Institute’s weekly e-mail newsletter.
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