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Anna Schwartz: Where We Are Getting It Wrong

Mark Thoma sends us to Anna Schwartz on the credit crisis:

The Weekend Interview: Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again.... Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs. 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....

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.... "If the borrowers hadn't withdrawn cash, they [the banks] would have been in good shape.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....

Ms. Schwartz argues... 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.... It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues. "I think if you have some principles and know what you're doing, the market responds. They see that you have some structure to your actions, that it isn't just ad hoc -- you'll do this today but you'll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what's going on. So I think if you're tough about firms that have invested unwisely, the market won't blame you. They'll say, 'Well, yeah, it's your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you're stuck with assets you can't sell and liabilities you can't pay off?'" But when the authorities finally got around to letting Lehman Brothers fail, it had saved so many others already that the markets didn't know how to react. Instead of looking principled, the authorities looked erratic and inconstant.

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...

So she has become a Mellonist. Back in her (and Milton Friedman's) Monetary History of the United States, she argued that Treasury Secretary Andrew Mellon and company were wrong when they told Hoover, as Hoover put it, to liquidate the economy:

The 'leave-it-alone liquidationists' headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate'.He held that even panic was not altogether a bad thing. He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'...

But today she says that Andrew Mellon's policy is the right one.

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