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Saturday, October 18, 2008

Anna Schwartz on Fed and Treasury Responses to the Financial Crisis

I think Anna Schwartz is too hard on Ben Bernanke with respect to the illiquidity versus insolvency issue, I think Treasury Secretary Paulson was the one who didn't have a firm grasp on this distinction and the implications for policy (I'm not alone), and he was the one who had to be dragged screaming and kicking into recapitalization, and I worry more about systemic risk than she does, but she makes some good points and she's earned the right to be heard:

Bernanke Is Fighting the Last War, by Brian M. Carney, Commentary, WSJ: ...[Anna] Schwartz ... co-authored, with Milton Friedman, "A Monetary History of the United States" (1963). It's the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression. ... Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again. ...

We now hear almost every day that banks will not lend to each other... This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. "The Fed," she argues, "has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible." ... 

In the 1930s, as Ms. Schwartz and Mr. Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. ... But "that's not what's going on ... now," Ms. Schwartz says. Today, the banks have a problem on the asset side of their ledgers -- "all these exotic securities that the market does not know how to value."

"...[Y]ou don't know what they're worth, your balance sheet is not credible and the whole market freezes up. ... So if you could get rid of them, that would be an improvement." The only way to "get rid of them" is to sell them, which is why Ms. Schwartz thought that Treasury Secretary Hank Paulson's original proposal to buy these assets ... was "a step in the right direction."

The problem with that idea was, and is, how to price "toxic" assets that nobody wants. ... If they are priced at current market levels, selling them would be a recipe for instant insolvency at many institutions. The fears that are locking up the credit markets would be realized...

Ms. Schwartz won't say so, but this is the dirty little secret that led Secretary Paulson to shift from buying bank assets to recapitalizing them directly... But in doing so, he's shifted from trying to save the banking system to trying to save banks. ...Ms. Schwartz argues [that] by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. ... Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake.

Ms. Schwartz doesn't buy it. ... It takes real guts to let a large, powerful institution go down. ... "I think if you have some principles and know what you're doing, the market responds. They see that ... it isn't just ad hoc... [W]hen the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn't know how to react. Instead of looking principled, the authorities looked erratic and inconstant.

How did we get into this mess in the first place? ... "If you investigate individually the manias..., in every case, it was expansive monetary policy that generated the boom in an asset. "The ... too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

The house-price boom began with the very low interest rates in the early years of this decade under former Fed Chairman Alan Greenspan. ...

Fed Chairman Ben Bernanke, of all people, should understand [all of] this, Ms. Schwartz says. ... He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."

Change "Fed" to "Treasury" in the last sentence, and I am more inclined to agree.

Update: Brad DeLong adds:

So she has become a Mellonist. Back in her (and Milton Friedman's) Monetary History of the United States, she argued that Treasury Secretary Andrew Mellon and company were wrong when they told Hoover, as Hoover put it, to liquidate the economy:

The 'leave-it-alone liquidationists' headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'.He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'...

But today she says that Andrew Mellon's policy is the right one.

    Posted by on Saturday, October 18, 2008 at 01:53 PM in Economics, Financial System, Policy | Permalink  TrackBack (0)  Comments (26)

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