Ron Paul’s economic philosophy and book End the Fed got some crucial publicity and thoughtful debate on Saturday. Simon Johnson, MIT economist and former IMF chief-economist, wrote in the New York Times economics blog that more people should take Dr. Paul seriously. Unfortunately he advises Dr. Paul promote some very anti-free market, and counter-productive measures. Johnson wishes Paul would advocate a trust-busting maneuver regarding big banks.

For Johnson, a key cause of our economic woes is that the banks are too big. He advocates breaking them up to solve the problem. Why he advocates this and not doing away with the initial interventions that allowed the banks to grow so large is beyond me. One of the key aspects of the current banking system is that it allows big banks push their losses on the people with bailouts. Thus, by simply allowing them to fail instead of bailing them out, big banks would have their “power” stripped of them. Indeed, diminishing the size and scope of government prevents bankers, other large corporations, and special interests from obtaining privileges and regulatory capture.

Also, Mr. Johnson, why exactly do you despise large banks? Who are you to decide upon the best, most efficient, size of a firm which provides banking services? Such organizational decisions as the size of a firm are made on the market by entrepreneurs using economic calculation. Johnson’s position that smaller banks are better than larger banks is based upon arbitrary whim and is utterly meaningless.

Mr. Johnson writes, “The only way to restore the market is to compel the most powerful players to become smaller.” What an absurd statement! The only real way to restore the “market” is to remove the government intervention which distorts the most efficient and consumer satisfying outcomes. The myth that government action to break up large firms somehow benefits the economy (ultimately consumers) is what I intend to expose with this post.

Banks are an enterprise that provides consumers with services they value just like any other business (granted the banking industry would look a lot different on a truly free market, as in no Fed). Let take a hypothetical example to illustrate my point. What if there was a huge car company that, at some point in time, captured a massive share of the market, say 55%. They achieved this market share by providing what consumers want in the most resource-efficient way and have out-competed the other car companies. Should they be broken up on account of their size? No. Doing so would upset consumers who wanted to purchase the cars while not improving anybody in a demonstrable way. Thus, the act of coercively breaking up a firm hurts the consumers who have repeatedly demonstrated their preference for that particular manufacture’s goods. The demonstrated preference for the extra-large automaker is the necessary precondition for them to become so large. The act of breaking up a firm also demonstrably hurts the owners who have organized land, labor, and capital in the most efficient way. To break them up must cause inefficiency and the misallocation of resources. If breaking up into smaller autonomous companies resulted in a more efficient and consumer satisfying outcome, the producers would have already done so in their search for higher returns.

The concept of Pareto optimality is very important to this discussion and others relating to government policy. An action is Pareto optimal when it demonstrably helps someone and demonstrably hurts no one. All actions on the free market satisfy this requirement because they are made voluntarily. Actions that violate property rights (crimes) are not Pareto optimal. Government actions, because of their coercive nature, do not satisfy the requirement of Pareto optimality. When Mr. Johnson suggests that the best course of action is to “compel the most powerful players to become smaller,” he is suggesting an action which is not Pareto optimal. The word compel is very important. It means the owners of large banks will be forced by the full power of the state to give up control of their property. Even though the stated goal of breaking up the banks is to “restore the market,” as Johnson puts it, there is no way of knowing how many pieces the firm should be broken into. The state has absolutely no rational basis for deciding how large a firm should be, whether it’s a car producer or the producer of banking services.

Breaking up large banks via arbitrary decree of the state will not restore the market. As Rothbard (Power and Market, p. 320) points out, one intervention always leads to more complications and problems which require either additional interventions (which then require even more interventions) or a repeal of the initial intervention. If the state broke up big banks, it would also have to enact legislation to prevent small banks from becoming large. Then it would also have to enact legislation which would prevent small banks from trying to organize their assets together in such a way that mimicked the efficiency of larger banks (banks with different names the same management).

To understand how to truly restore the market, it behooves us to understand just precisely what we mean by the market. The market is nothing more than the conceptualization of the aggregation of all the exchanges voluntarily made between two or more parties. The key here is that the market is a word we use to describe the entire nexus of voluntary exchange. The fact that the exchanges must be voluntary to be considered part of the market ties us back to the idea of Pareto optimality. It is completely fallacious to say that we need a coerced reallocation of resources in order to improve the voluntary allocation of resources on the market.

The size of a particular firm is value neutral, meaning it isn’t clear whether it’s good that a firm is large or bad. We can only say that the size of firm is good or bad if we take a look at how a firm got to be so big. If the firm used government intervention in the form of regulation or a cartel like the Fed to become so large, we can say that its size is unjustified on the basis consumer satisfaction and demonstrated preferences. This is the situation with the banking industry. Bankers and politicians have been best friends since people first began using banks. Bankers have always seen the state as way to increase their size and returns while politicians have always seen banks as a source of politically expedient funding (debt and inflation are easier to slip by the average Joe than is a raise in his taxes).

Unless you remove the underlying causes for banks getting so large, they will just get large again. We must remove the existing government interventions that have allowed banks (and other huge corporations) to get so large and powerful. Advocating new interventions, as Mr. Johnson does, is not the answer.