Months ago—seriously, it seems like almost a life time ago—famed economist Anna Schwartz warned us that not allowing banks and financial firms that had brought themselves to the brink of collapse was a recipe for economic disaster. Since she wrote the book—literally, she wrote the book with Milton Friedman—that most economists and regulators (including Ben Bernanke) cite as their guide to handling a financial crisis, the fact that this lesson still hasn’t taken is disturbing.
So exotic is Schwartz’s solution that Michael Lewis and David Einhorn (pictured here) had to propose it again this weekend.
There are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.
Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honour, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.
So why isn’t this happening? Until sometime around December, something along these lines was our de facto national policy. Bear Stearns is gone. Lehman is gone. Merrill Lynch is gone. That’s reassuring. But since that fateful weekend in September, we seem to have abandoned this approach in favour of a policy of No Failure. And so today huge financial firms like AIG and Citi continue on government life support.
What went wrong? It strikes us that the problem was just an awful combination of special interest politics and a failure of nerve. There was little short term gain for, say, Hank Paulson to preside over the liquidation of more firms and lots to be gained by established financial institutions from successfully lobbying for bailout. And now that dynamic has become a pattern, with automaker interests discovering they can extract billions from disorganized taxpayers with little incentive to mount a counter-offensive.
Surprisingly, it seems that some market watchers are under the impression that our problem is that we’re still too addled with free-market ideology. Ryan Chittum, who writes The Audit for the Columbia Journalism Review, nicely exemplifies this point of view. Applauding the Einhorn and Lewis proposal of orderly liquidation of failed firms, Chittum writes:
“The only thing preventing that is the vestigial free-market religion that somehow hasn’t been expunged yet—you know, the one that says we can’t tell insolvent banks that led us to ruin what to do, even though we’ve given them hundreds of billions of dollars to keep them afloat because they didn’t know how to run their businesses.”
As an aside, we’re not sure how bailouts fit any sort of “free-market religion.” In fact, propping up AIG and Citi seems to be the opposite of a free-market approach. If free-marketeers really were a religious cult, surely Hank Paulson and Ben Bernanke would have been excommunicated. Paulson and Bernanke long ago started revering very different idols and holding to an unorthodox cannon.
But beneath the semantic point, Chittum is on to something. The idea that the gang that led us into the financial quagmire should be entrusted with billions more of our nation’s wealth certainly needs to be expunged. Maybe that should be our New Year’s resolution.