So why isn’t the bailout working? They say generals are always fighting the last war. Now Ben Bernanke, who was a financial historian before he became a World Saver, may be fighting the last depression. Unfortunately, our current economic crisis is not like the one we faced in the 1930s. It’s almost its photographic negative. Policies designed to avert the last depression may actually be prolonging this crisis.
In the Great Depression, banks that were otherwise solvent, if not entirely healthy, were being brought down by panic driven bank runs and a lack of liquidity. That truly was a liquidity crisis. The Federal Reserve had it within its power to support the banks by adding liquidity but it refused to do so. Since then an academic consensus has developed around the theory that it would have been better for the Fed to take an active role in preventing the crash of solvent financial institutions.
Our problem is very different. As we’ve seen from the wreckage of Lehman Brothers, Bear Stearns and Merrill Lynch, many of our financial institutions are insolvent. They aren’t healthy victims of bank runs. They are ailing institutions barely kept alive by frantic rounds of capital raising. The lessons of the Great Depression simply don’t apply here.
In fact, we’re probably making things worse. Allowing insolvent institutions to fail and requiring worthless and worth less assets to be fully written down would provide transparency to the market. Instead, we’re dedicated to the post-Lehman proposition of “Never Again.” The various programs of our government continue to obscure asset pricing and conceal insolvency. This means that you can’t trust the market to tell you which firms are failing.
Twisting the arms of bankers to lend to institutions that may be insolvent is a recipe for deepening the crisis. We’ve just been through a period of malinvestment–we spent too much borrowed money on junk. Borrowing more to spend on junk only digs us in deeper.
Bank lending won’t get going again until trust in the markets can be restored. Fighting a Great Depression era problem probably won’t help. More transparency, which means more write-downs and failures, is probably necessary if we’re going to get through this. Unfortunately, we’re still sailing in the opposite direction.