Answering Krugman
Paul Krugman comments on something I said on TV this past weekend:
I don’t always agree with Naomi Klein, and I don’t always disagree with David Frum, but Klein wins this one hands down: Frum worries that financial regulation might crush “the creativity of the system,” Klein counters that “we could all do with them being a little less creative.”
This is usually framed, less colorfully, in terms of “financial innovation”, but the point needs to be repeated again and again: at this point, there is no reason to take it on faith that cleverness in the financial industry is a net social good. Unless you can provide some clear evidence of productive innovations since regulation began to unravel — and ATMs don’t count — the balance of the evidence suggests that smart people have been devising ingenious ways to concentrate risk and direct capital to the wrong uses.
John Bogle of Vanguard offers one answer to this challenge in today's Wall Street Journal: the index fund. (Although Bogle has many other severe things to say about the financial services industry.)
Here's another: the interest-only mortgage. A generation ago, the interest-only mortgage was a rarified device typically available only to the super-wealthy clients of institutions like Banker's Trust. In the 1990s and 2000s, the interest-only mortgage was democratized: today about 1 in 10 American mortgage-holders has one.
Interest-only mortgages are often grouped with low-down-payment mortgages as culprits in the housing meltdown.
But used responsibly, they can be a beneficial tool. Once a homeowner has reached a satisfactory level of equity in his or her dwelling, it does not necessarily make sense to concentrate further saving into the principal residence. It might make more sense to accumulate other kinds of assets - or, for a small business owner, to direct capital into the business instead.
More broadly: Yes of course looking back on any period in economic history, you'll find many examples of smart people directing capital to the wrong uses. Way too many railway lines were built in the 19th century; the sodbusters opened too much western land; nobody wanted the Hupmobile and the Stanley Steamer; the skyscrapers of the 1920s did not hit full occupancy for a generation; Silicon Valley went nuts in the 1990s.
But directing capital to the wrong uses is a necessary part of the process of directing capital to the right uses. It's a point that has been made by thinkers from Frederic Bastiat to Virginia Postrel: the defense of free markets is not only a defense of what has been accomplished - it is a defense of possibilities as yet unaccomplished. Economists and statisticians can calculate in retrospect what went wrong and went right in the 2000s. Trying to raise the home ownership rate over 64%? Bad idea. Technology to enable people to upload video of kittens to the Internet? Good idea.
Discerning the good and bad ideas in advance, however, is a rather more testing undertaking. And if you think it's risky to allow markets to guess - just what till you see what happens when you order markets to stop.