The economist who knows more about how to solve a banking crisis than anyone else says we’re screwing this up.
Anna Schwartz wrote the book on the last great banking crisis. That book was called “A Monetary History of the United States,” and it was co-authored by the far more famous Milton Friedman. She says the bailout would have worked if it forced banks to take serious write downs on junk assets and allowed imploding banks to fail. Unfortunately we’re doing the opposite.
The TED spread has improved and equity markets have gone on a tear this afternoon. But we may not be out of the woods yet. All the confidence in the government’s plan could be misplaced, Schwartz implies.
The Wall Street Journal ran the interview with her in their weekend edition.
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 So bank runs began, and these became self-reinforcing: “If the borrowers hadn’t withdrawn cash, they [the banks] would have been in good shape.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.”
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 realised, 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 recognises 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.”
Editors Note: We linked to this over the weekend but figured you may have missed it. Also, we like Schwartz’s view because it aligns so nicely with what we said last week. Maybe Anna reads Clusterstock!