Tuesday, October 21, 2008

My Hero Anna Schwartz

Anna Schwartz co-authored "A Monetary History of the United States" with Milton Friedman. While the monetarists have their own issues, she gave an interview to the Wall Street Journal this week on the financial crisis, "Bernanke is Fighting the Last War, and it is superb. She made five key points that echoed themes I've been discussing in the past weeks.

First, the current Federal policies are not addressing the fundamental cause of the confidence problem. That cause is distressed balance sheets which can only be fixed by write down and recapitalization.

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."

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Second, bank failures are not the end of the world, and in fact are part of the restructuring process that is needed.

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."

Third, the idea of "systemic risk" as a Doomsday scenario is bogus, and only propagates the "too big to fail" mindset.

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'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."

Fourth, regardless of market forces that reacted during the buildup, one of the underlying causes was loose money policy at the FED. Anna, as a monetarist obviously focuses on this as a primary cause, but I can forgive that. I like this development, not so much for it's errors, but because of the fundamental idea that seemingly unexplainable phenomena are explainable. That mysterious "booms" are not so mysterious.

How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

"The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and 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."

And finally, on Alan Greenspan's role in the mess,

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

"Now, Alan Greenspan has issued an epilogue to his memoir, 'Time of Turbulence,' and it's about what's going on in the credit market," Ms. Schwartz says. "And he says, 'Well, it's true that monetary policy was expansive. But there was nothing that a central bank could do in those circumstances. The market would have been very much displeased, if the Fed had tightened and crushed the boom. They would have felt that it wasn't just the boom in the assets that was being terminated.'" In other words, Mr. Greenspan "absolves himself. There was no way you could really terminate the boom because you'd be doing collateral damage to areas of the economy that you don't really want to damage."

I have an entire post on the revisionist perspective that Alan Greenspan has himself put to his decisions and actions. However, every time I sit to write it, I get too infuriated to finish it. This particular account made my blood boil as it shows in his own thinking the pragmatist and sell-out he has become. And in the end in doing so he's become capitalism's worst detractor.

Thanks Anna for saying what had to be said!


madmax said...

Thanks for bringing my attention to Anna Schwartz. Her analysis was one of the better things I've read on the economic collapse. I have a question about the Monetarists. I read the Wiki entry on them but I never trust a Wikipedia entry. Are Monetarists Austrians? Do they want to abolish the Fed or just tinker with it? The Wiki entry linked them with Keynes. I don't see how they can be Keynsians and opponents of inflation.

Galileo Blogs said...

Monetarists are not Austrians and do not advocate gold-based money. Milton Friedman, the father of monetarism, advocated increasing the money supply at a low, fixed rate, say 3% per year. He wanted to avoid the arbitrary ups and downs in the money supply that contributed to booms and busts, such as the Great Depression, but he thought steady, moderate monetary inflation was preferable to the gold standard.

Monetarists also endorsed the quantity theory of money, which establishes the connection between changes in the general level of prices and changes in the money supply.

They were better than Keynesians, but stopped short of going for the gold, i.e., a system of complete private property in banking (and all other areas).

Raf said...

Galileo.....Gold is as much subject to abuse as fiat currency. It didn't take the Bank of England long to have its first run once it started printing paper receipts against gold holdings. I don't think there has ever been a time when some kind of fractional reserve has been practised even when gold has been provided as backing.