“In the 1930s, as Ms. Schwartz and Mr. [Milton] Friedman argued in "A Monetary History," the country and the Federal Reserve were faced with a liquidity crisis in the banking sector. As banks failed, depositors became alarmed that they'd lose their money if their bank, too, failed. So bank runs began, and these became self-reinforcing: "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape. But the Fed just sat by and did nothing, so bank after bank failed. And that only motivated depositors to withdraw funds from banks that were not in distress," deepening the crisis and causing still more failures.
But "that's not what's going on in the market 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."
"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. 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 from the banks was "a step in the right direction."
The problem with that idea was, and is, how to price "toxic" assets that nobody wants. And lurking beneath that problem is another, stickier problem: 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, and a number of banks would probably fail.
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, as the Treasury did this week. But in doing so, he's shifted from trying to save the banking system to trying to save banks. These are not, Ms. Schwartz argues, the same thing. In fact, 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. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."”
Brian M. Carney, “Bernanke Is Fighting the Last War: An interview with Anna J. Schwartz”, The Wall Street Journal (18 October 2008).
http://online.wsj.com/article/SB122428279231046053.html
Brian M. Carney is an editor, journalist and member of the Wall Street Journal Editorial Board.
As mentioned in an earlier Tdj, at the age of 92, Professor Anna Jacobson Schwartz (1915 - ) is still an economist at the National Bureau of Economic Research in New York City, where she has worked since 1941. She jointed with Milton Friedman to publish in 1965 A Monetary History of the United States, a book that changed the understanding of how the world works for economists as well as politicians, policy makers, and journalists. The book blamed the Fed for causing the slump and in doing so it revolutionized thinking on the causes of the Great Depression. "The book was a bombshell," says British monetarist Tim Congdon. "Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression." In 2002, in a speech in honor of Mr. Friedman's 90th birthday, Mr. Ben Bernanke, then a Federal Reserve Board governor, said "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
But in Dr. Schwartz’s view they are about to do it again, that is, misunderstand the situation and rather than taking measures that would ameliorate the crisis, the Fed insists instead on making things worse. The “credit market disturbance”, as she puts it, is not, as the Fed believes, caused by a lack of money to lend but by “all these exotic securities the market does not know how to value”. Why are these exotic securities 'toxic'?" Ms. Schwartz asks. "They're toxic because you cannot sell them, you don't know what they're worth, your balance sheet is not credible and the whole market freezes up. We don't know whom to lend to because we don't know who is sound. So if you could get rid of [the bad securities], that would be an improvement." She initially thought Secretary Paulson’s idea to buy these assets from the banks was a good one but then realized it would not work because the low prices for the doggy securities would leave the banks insolvent.
She believe that market participants should be allowed to flourish or fail on their own, with as little government intervention as possible. She argues the government should not be recapitalizing firms that should be shut down." Rather, she bluntly says "firms that made wrong decisions should fail." Referring to the government, she says “I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?”
With regard to the Fed’s efforts to deal with the financial crisis she concludes "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."
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