Anna Schwartz Disagrees

Anna Schwartz does not feel compelled to impress people with her grip on yard-long equations and cosmic economic theory. She is naturally inclined, in the spirit of this blog, to explain complex problems in simple terms - the greatest gift any of us can make to our friends. (We are not always equal to the task but we give it our best shot.)

Readers recall that Schwartz in 1963 co-authored with Milton Friedman, "A Monetary History of the United States", a book which placed conventional wisdom about the cause of the Depression, squarely on its head. The last time we saw Schwartz was 10/93 when we two testified before the House Banking Committee on Fed reform. At 92 and still working at the NBER she remains an icon in the profession.

We heralded the administration’s about face in adopting Darling’s plan. We knew that the Fed had flooded the market in vain - no trust, no lending. We figured then that taxpayer capitalization would work to thaw the inter bank market, key to our troubles, and anyway, we didn’t think banks would cooperate with the other plan - endless arguing about the best price to sell their rubbish to us taxpayers. Recall that the 90 day LIBOR rate best reflects banks’ willingness to lend; prior to Paulson’s decision that rate was 4.82% but last it was 4.42% so indeed, there has been some improvement, some movement in money lent bank to bank since that announcement.

Chicken feed argues Schwartz. She says that resuscitating flawed institutions sets the wrong precedent, carrying a chronic infection with it. Recapitalize all you want; the so-called toxic securities will remain - no one knows how little they’re worth and despite the Fed’s or the adm’s efforts, if they remain we’re going nowhere quickly.

That is why Schwartz welcomed Paulson’s original plan when we did not. And why did Paulson abandon that plan and join Darling’s? Because if this garbage is priced at current market levels, selling this stuff, as Schwartz in quoted in a recent WSJ editorial, "would be a recipe for instant insolvency at many institutions." (Which is why we suspected they would not cooperate) Yet Schwartz argues that keeping insolvent firms afloat just prolongs the crisis. "Firms that made wrong decisions should fail," she says. "You should not 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...." .

Tough to argue with this, at least the theory. Well, perhaps with implementation. But what about "systemic risk" you may ask Schwartz, that risk originating from the opaque web connecting most of the world’s major financial institutions, the domino effect? She doesn’t buy that either, dismissing most of that noise to market whiners.

Finally this from Schwartz, an anchor no matter how we view the details: "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 is not just ad hoc—you’ll do this today but something different tomorrow. Now, instead of looking principled, the authorities looked erratic and inconsistent. 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 invested unwisely, the market won’t blame you."

Robert Craven