Monday, October 20, 2008

Anna Schwartz Gives Lessons to Policymakers

My Money & Banking students may remember that during our last class I postulated that the problem of asymmetric information in financial intermediation was probably the most important component of this financial crisis.

I also suggested that the Treasury's bailout plan made the information problem worse by keeping unhealthy banks afloat. The government is artificially creating a lemon market when it does not allow discrimination between healthy and unhealthy banks to occur via bank failures. Besides the redistributive problems that the bailout plan creates, it endangers the entire economy through planned obfuscation. An exemplary case of government failure.

Top economist Anna Schwartz, has just confirmed my suspicions. Here's what she said in an interview to WSJ's Carney:

[The credit market distrubance] 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."

Ms. Schwartz argues [that] ... 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. ...

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. ... 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."

It takes real guts to let a large, powerful institution go down. But the alternative -- the current credit freeze -- is worse, Ms. Schwartz argues.

... 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."

PS: Mankiw and White agree that those are wise advices.

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