Across six decades, she contributed strong work and commentary on economics, notably the financial system. In all her efforts to understand and explain financial behavior, Anna Schwartz focused on the system's primary need: stability.
Which brings us to the present economic instability, on which Schwarz had opinions that deserve to be heard again. Statements she made to this newspaper in a Weekend Interview three and a half years ago, in her early 90s, ring with clarity and relevance to current difficulties: "The Fed 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."Please re-read the highlighted text as Mrs. Schwartz has nicely summarized what your humble blogger has been saying since the beginning of the bank solvency led financial crisis.
There is only one way to return 'stability' to the financial system and end uncertainty about the balance sheets of financial firms: require ultra transparency and make the banks disclose on an on-going basis their current asset, liability and off balance sheet exposure details.
With this data, market participants can independently assess each bank and be confident in making buy, hold and sell decisions based on this assessment.
From her WSJ Weekend Interview,
She speaks with passion and just a hint of resignation about the current financial situation. And looking at how the authorities have handled it so far, she doesn't like what she sees...
Federal Reserve Chairman Ben Bernanke has called the 888-page "Monetary History" "the leading and most persuasive explanation of the worst economic disaster in American history."
Ms. Schwartz thinks that our central bankers and our Treasury Department are getting it wrong again.
To understand why, one first has to understand the nature of the current "credit market disturbance," as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. 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.An observation that also appeared in the Financial Crisis Inquiry Commission report.
This uncertainty, says Ms. Schwartz, is "the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."Please re-read the highlighted text as it confirms what your humble blogger has been saying since the beginning that it is a bank solvency crisis.
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."...While Ms. Schwartz understands the need for valuing structured finance securities, she does not understand that they present the identical problem that banks present: they are opaque.
The only way to answer which bank is solvent and which is not is to require ultra transparency.
The only way to value structured finance securities is to require observable event based reporting on the underlying assets. Under this reporting, investors have access to current performance information as every activity like a payment or delinquency is reported before the beginning of the next business day after it occurs.
But in doing so, [Mr Paulson] 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 recognizes 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."
Instead, we've been hearing for most of the past year about "systemic risk" -- the notion that allowing one firm to fail will cause a cascade that will take down otherwise healthy companies in its wake.
Ms. Schwartz doesn't buy it. "It's very easy when you're a market participant," she notes with a smile, "to claim that you shouldn't shut down a firm that's in really bad straits because everybody else who has lent to it will be injured. Well, if they lent to a firm that they knew was pretty rocky, that's their responsibility. And if they have to be denied repayment of their loans, well, they wished it on themselves. The [government] doesn't have to save them, just as it didn't save the stockholders and the employees of Bear Stearns. Why should they be worried about the creditors? Creditors are no more worthy of being rescued than ordinary people, who are really innocent of what's been going on."The reason the ultra transparency is needed is so that lenders can once again be responsible for their decisions.
So long as governments have a monopoly on the information disclosed under ultra transparency, there is a moral hazard. The moral hazard is the need to bailout investors after the government says that a bank is solvent.
It takes real guts to let a large, powerful institution go down....As your humble blogger has said many times, a modern banking system is designed so that banks can absorb all the losses on the excesses in the financial system without having to be closed down. Between deposit insurance and access to central bank lending, banks have ample liquidity.
As a result, banks can continue to support the real economy and retain 100% of future pre-banker bonus earnings to rebuild their book capital levels.
In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman's 90th birthday, "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
"This was [his] claim to be worthy of running the Fed," she says. He was "familiar with history. He knew what had been done." But perhaps this is actually Mr. Bernanke's biggest problem. Today's crisis isn't a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. "I don't see that they've achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job."Which is not surprising because they are fighting a bank solvency crisis and not a bank liquidity crisis.
The solution to a bank solvency crisis is adopting the Swedish model with ultra transparency.