11 June 2009

Co-Author of 'A Monetary History of the United States' Takes Stock

If you've never read the classic and important history of economics book, 'A Monetary History of the United States,' it's well-worth your time to pick it up and spend the summer reading it. The co-authors of this seminal work are Anna Schwartz and Milton Friedman (the Noble prize winner who famously advocated greed and free market forces).

Dr. Schwartz (who is a spry 93) has spent sixty years working for the National Bureau of Economic Research in New York. Like Milton Friedman, she is a numbers person - she's hell on data, and knows what she's talking about. Kai Ryssdal played an interview with her two days ago on Marketplace, specifically as relates to the TARP payouts and the actions of the Federal Reserve over the last year. Suffice it to say that she's deeply unhappy with the constant move to bailout banks and firms, and the White House moves to take control of private equity and management.

ANNA SCHWARTZ: "The Federal Reserve could easily have provided additional money supply. That would have helped the banks that were losing deposits and that would have helped the economy in general. ... I think both Bush and the Obama administration have not been as hard headed with banks, it has been too lax. And instead if they had said if you cannot raise capital in the market, there is no reason for the government, the people of this country, to provide capital."

Ryssdal: "OK, but wait a minute. Didn't we try that with Lehman Brothers last September? And there are people who will say that only made everything worse. Should we now say to Bank of America, and Citigroup and some of these other banks, "Hey, you can't make your loans..."

SCHWARTZ: "No, the trouble with the way the Fed operated when it rescued Bear Stearns, the market then believed this was a signal of the way the Federal Reserve would perform. If the Fed and the Treasury made a candid statement to the market: We will help a bank, which basically is solvent. We will not do that for a bank, which is on the verge of bankruptcy. And then the market understands there are principles. That's why when Lehman Brothers was permitted to fail, the market was simply bewildered. Because here you had treated Bear Stearns in this kindly fashion, and what reason was there not to do the same when Lehman Brothers arose? ... The market is just bewildered. Bernanke came into office insisting that the Fed would be much more transparent than it had been in the past. But I don't believe that it's lived up to that. If the market understood what the Fed was planning in each case, and could see a design, then I think the market would have reacted much more positively. ... No, and I think the big shortcoming of the Obama administration, and Bush before that, was that it didn't make a concerted effort to get rid of these assets. I mean in a sense it's a condemnation of the Federal Reserve. They did not respond to securitization, which is the basic condition for the creation of these toxic assets. Neither Alan Greenspan or anybody else at the Fed seemed to be concerned."

This discussion fell in line with a Wall Street Journal article from last years (Aug. 9, 2007) by Brian Carney entitled, 'Bernanke is Fighting the Last War.' Carney interviewed Dr. Schwartz:

'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. 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." .... Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on." It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues. "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?'" But when 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.'

When this lady speaks, we should all be listening closely. The interview and article tied in nicely with another Marketplace report about the TARP program and the difficulty some institutions are having in convincing the government to allow a rapid loan repayment.

Kai Ryssdal: "Recall though that back in October then-Treasury Secretary Henry Paulson met with the CEOs of nine of this country's biggest banks. He told them in no uncertain terms that they had to take the TARP money to save the whole financial system. So they did. Only to learn later that the money came with strings attached. So the race has been on to give that bailout back. Today 10 big banks got permission to do that. Almost two dozen smaller ones have already. Treasury Secretary Timothy Geithner, who was in the room with Paulson and the CEO's back in October, today called those repayments an encouraging sign of financial repair. Our Washington bureau chief John Dimsdale reports."

"But William Isaac at the financial consulting firm LECG Global says the banks that are returning the TARP money never needed it, and it didn't do them any good. ... The banks that got permission to payback the bailout performed well on those government-run stress tests. But the Congressional overseer of the bailout, Elizabeth Warren, today questioned whether the stress tests were stressful enough. For example, she said, the tests assumed an 8.9-percent unemployment rate. And last month, unemployment was 9.4 percent."

It seems we're going to be in for a long period of poor decision-making on the part of the White House and the Federal Reserve, and it sure seems to smack of a power grab when decision-makers ignore all common sense and the advice and warnings of some of the most experienced people out there to proceed with a plan. Models are fabulous things, but when they're not tested by real-world data (or when they fail tests), they can not be used reliably. The government seems to be bent on using a set of models that are untested, and on making crucial economic decisions based on those models. If it continues down this path, we're going to lengthen the credit freeze, devalue the currency to absurd levels, and create debt that will take decades to dig ourselves out of.

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