Tearing Into the Fed and Treasury Plans
online.barrons.com
Pre-eminent economist Anna Schwartz thinks the shortcomings of
the U.S. bailout plan will only lead to further problems in
the credit market.
ANNA SCHWARTZ, CO-AUTHOR WITH Nobel Laureate Milton Friedman
of the seminal A Monetary History of the United States, has
worked with the National Bureau of Economic Research since
1941, and remains an adjunct professor emeritus at the
Graduate Center of the City University of New York. About to
turn 93, she has spent most of her professional life studying
how the changes in money supply interact with inflation --
both within the United States and abroad.
Gary Spector for Barron's
"The chief problem is that the Treasury can responsibly
provide capital only to solvent institutions, but should not
recapitalize insolvent institutions. The current program
offers no way of determining who is solvent and who is
insolvent," says monetary authority Anna Schwartz.
When it comes to the unprecedented lending by the Federal
Reserve Bank under Chairman Ben Bernanke and new and untested
programs from the Treasury and its head, Henry Paulson, she
doesn't like what she sees.
Her prescription: Stop managing by press release. The federal
government needs to turn off the liquidity spigot and
quarantine bad assets. Ad hoc program announcements have only
undermined faith in the U.S. financial system, in her view,
and, if continued, could raise fears that ultimately threaten
the U.S. financial system. Here are more of her provocative
thoughts on the current crisis.
Barron's: Professor Schwartz, what are your regrets about the
government's handling of the credit crisis?
Schwartz: If I regret one thing, it's that Milton Friedman
isn't alive to see what's happening today. It's like the only
lesson the Federal Reserve took from the Great Depression was
to flood the market with liquidity. Well, it isn't working.
Professor Friedman would have enough stature to get them to
listen and stop pooh-poohing any notion of possible inflation.
It is also regrettable that the Shadow Open Market Committee
is no longer active. It was a group of private economists that
until two years ago met semi-annually to comment on policy
actions of the U.S. monetary authorities. If the group were
issuing policy statements too, they would be providing the
public with an independent judgment on the merits or
shortcomings of the authorities.
So you find today's policymaking frustrating?
It's like there's a bunch of guys that are making it up as
they go along. They talk about transparency and what they
present is opacity, programs that don't make sense, or are not
yet fully laid out. This only increases the already high level
of uncertainty and anxiety.
Disclosure's a problem. With the bailouts of Bear Stearns,
AIG, and the failure of Lehman Brothers, we have yet to
receive a full explanation of the reasons for either rescuing
the banks or, in the case of Lehman, letting them fail. Why
did the Fed rescue Bear Stearns, yet let Lehman Brothers go
under? There's clearly not enough disclosure to show if they
are approaching the problem in a systematic manner or are
playing favorites. Who knows? These unanswered questions only
add to the fear in the system.
Accountability, or its absence, is a theme of yours.
Indeed. The Federal Reserve has used its balance sheet in ways
never before seen, leveraging it by 25%. It now lends to banks
and brokerage firms and companies in a series of programs
ranging from the support of asset-backed paper, money funds,
the London offices of Goldman Sachs, Morgan Stanley and
Merrill Lynch, and also AIG. These programs come on top of the
TARP passed in Congress this
month.
Do you believe that the real problem comes not so much from
troubled mortgages but the inability of banks to price
securities they have created in the secondary market?
The problem comes from the introduction of new instruments and
the difficulty in pricing these securities or pools of
mortgages. The trouble is that mortgage pools are made of
good, bad and insufficient mortgages, and it's hard to name a
price. To make matters worse, the rating agencies were used to
rate the securities. And they came up with ratings in an
arbitrary manner without really doing due diligence. Now no
one has any idea of how to price these securities. And the
rating agencies are lowering the ratings on some of the
instruments to which they have given top grade.
Another spinoff from mortgage-backed securities is credit-
default swaps. There was no way of evaluating what effect a
downturn would have on the derivatives markets and their
counterparties. Few who deal in the derivatives market have a
clear notion of their responsibilities. We have a bewildering
array of instruments with uncertain prices. And as a result,
we don't know who's solvent and who's not. The problem comes
from a lack of ability to price the instruments, not a lack of
liquidity. Evidence of the banks' unwillingness to lend can be
seen in the most basic Federal Reserve statistics, which show
that in the week ended Oct. 1, the banks had $167 billion of
balances with the Federal Reserve, whereas on July 2 there was
only $14 billion. Clearly the banks are holding the money and
failing to pass it on in new consumer loans and business,
preferring instead the safety of the vault.
So the trouble comes from not knowing the shape and size of
the players and the exposures they have in various markets.
We also need to learn whether or not security holders are responsible for their counterparties.
How do you coordinate rescue programs both domestically and overseas?
We arguably have an obligation to help clean up Europe because
we persuaded investors there to buy these securities, because
of their high ratings, and they've been left high and dry. The
Federal Reserve's recent creation of "unlimited" billions of
dollars in currency-swap lines to central banks like the Bank
of England, Bank of Japan, the European Central Bank and the
National Bank of Switzerland helps in this regard.
These institutions arguably assist the various rescues without
necessarily having to sell dollars to raise the available
funds. But there's too little information about how these
loans are being made. For what duration, and on what terms.
Transparency will only serve to increase faith that the
measures are occurring in the open.
But you contend that the most work needs to done on the
Paulson plan.
The $700 billion Paulson package represents further problems
because of the ad hoc way it seems to be cobbled together.
Originally the hope was that the program could absorb all the
bad assets on the balance sheets of banks so they could start
over. No one has come up with an exact program for dealing
with the bad assets once the Treasury buys them. How are they
going to price the assets that the Treasury ultimately
purchases? No one has come up with a way to price these new
securities. Now, however, the bad-asset programs seem to have
been set aside in favor of a program to recapitalize financial
institutions.
But won't all these multi-billion-dollar programs in time
create inflation?
Up until the middle of 2008 the Federal Reserve balance sheet
had not experienced an annual growth rate well above the
traditional 5%. Since mid-summer, Fed credit appears to have
ballooned greatly, and that's behind the upward pressure in
the consumer price index. The Fed pooh-poohs inflation because
of a perceived slowdown in oil and gas prices. But
theoretically any increase in the monetary base must be met
with a tightening if inflation is to be avoided. Right now the
Fed is pursuing a pro-inflation strategy by lowering interest
rates and showering the banking system with liquidity. They're
not even considering inflation. Paul Volcker learned that
success in fighting inflation comes from tightening monetary
policy, even if the public holds you responsible for
disinflation.
Is there anything to like about the Paulson plan?
The first real positive sign was the original Paulson package.
It seemed to be a move in the right direction. But it's been
superceded and is short on specifics. How were they going to
price these assets? Who were they going to hire to buy the
assets for the federal government? Will they be friends of
Goldman Sachs, BlackRock? There's precious little detail about
how they're going about this plan. What about the chance of
holdouts? And what does the government do with the paper once
it buys it?
The way you clear up problems in the credit market is through
coming up with a clear, understandable plan and then executing
it precisely.
Just how high are the stakes?
My hope is that they will solve the problem by doing a bang-up
job. But there's already been talk about having to come back
for more money. The risk of being unclear and doing things ad
hoc is that you gradually destroy faith in the financial
system. And complete loss of faith leads to the imposition of
a bank holiday, the closing down of the system, to reassure
the public of the solvency of banks.
We're not there yet. But if we keep making things more
uncertain, and feeding the fear without minimizing the
problems, we could eventually make it so that Americans lose
faith in their financial system.
The program now is to recapitalize financial institutions on
the questionable premise that the accounting of potentially
bad assets on the bank balance sheets is correct and accurate.
The chief problem with this program is that the Treasury can
responsibly provide capital only to solvent institutions, but
should not recapitalize insolvent institutions. The current
program offers no way of determining who is solvent and who is
insolvent. We have a dilemma.
Thank you, Anna.
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