Anna Schwartz: The Fed's Performance 'Has Been Disappointing'

I disagree with Anna Schwartz with respect to the Lehman Brothers bailout - she contends that the trouble started when the (ill-advised) rescue of Bear Stearns set up expectations that Lehman would be treated similarly - but if Bear Stearns or another large bank had been allowed to fail instead, I think we would have seen the same panic in financial markets. But as noted below, I don't disagree with all of her criticisms of the Fed:

Taking Stock: Lessons from History, MarketPlace [audio]: Kai Ryssdal: ...Anna Schwartz [is] 93 years old, an economist for more than 60 of them. Still working, every day, at the National Bureau of Economic Research in New York City. Her area of expertise is monetary policy... Specifically, she's an expert in how the Fed blew it during the Great Depression... When I sat down with her in her office..., she made it clear she's none too happy about all of Washington's bailouts, or how the Fed and the Treasury chose who got one and who didn't.

Schwartz: I think both Bush and the Obama administration have not been as hard headed with banks, it has been too lax. And instead if they had said if you cannot raise capital in the market, there is no reason for the government, the people of this country, to provide capital.

Ryssdal: OK, but wait a minute. Didn't we try that with Lehman Brothers last September? And there are people who will say that only made everything worse. ...

Schwartz: No, the trouble with the way the Fed operated when it rescued Bear Stearns, the market then believed this was a signal of the way the Federal Reserve would perform. If the Fed and the Treasury made a candid statement to the market: We will help a bank, which basically is solvent. We will not do that for a bank, which is on the verge of bankruptcy. And then the market understands there are principles. That's why when Lehman Brothers was permitted to fail, the market was simply bewildered. Because here you had treated Bear Stearns in this kindly fashion, and what reason was there not to do the same when Lehman Brothers arose?

Ryssdal: Now do you think the market has figured out what the policy of the federal government is toward these rescues by now? It's been six, seven months since Lehman Brothers.

Schwartz: The market is just bewildered. Bernanke came into office insisting that the Fed would be much more transparent... But I don't believe that it's lived up to that. If the market understood what the Fed was planning in each case, and could see a design, then I think the market would have reacted much more positively.

Ryssdal: It sounds like you're frustrated with Chairman Bernanke...

Schwartz: Well, I think that that's a fair statement. ...Bernanke's ... performance ...[s]eemed to be ... ad hoc and introduced without considering all the implications.

Ryssdal: You know, Alan Greenspan was lionized in this country for many years. And then a year ago went up to Capitol Hill and said, "You know what, I blew it." Does he get the appropriate amount of credit and/or blame for this whole thing?

Schwartz: Well, I think the verdict of history will be different with regard to his stature than it has been so far.

Ryssdal: In your mind, these toxic assets, the bad assets that these banks still have on their books, are they still a big problem or have they worked their way through the system now?

Schwartz: No, and I think the big shortcoming of the Obama administration, and Bush before that, was that it didn't make a concerted effort to get rid of these assets. I mean in a sense it's a condemnation of the Federal Reserve. They did not respond to securitization, which is the basic condition for the creation of these toxic assets. Neither Alan Greenspan or anybody else at the Fed seemed to be concerned.

Ryssdal: Securitization, that is the buying and selling of these packages of mortgages. There are those who will say it contributed a lot to the economic growth in this country. Do you buy that?

Schwartz: Well, I suppose the people who made money on it will say, Sure. But you have to be able to divine what you're letting yourself in for,... nobody took action to say, "Wait a minute. What are we doing when we are permitting these mortgage companies to issue these securities backed by a pool of mortgages of varying quality, and you don't know how to price the security?" Nobody raised that question.

Ryssdal: When an economic historian comes along in 25 or 30 years and tries to do for this episode what you and Professor Friedman did for the Great Depression, what's their verdict going to be...?

Schwartz: ...I don't know whether the verdict will be charitable. It's always possible to find reasons why other alternatives were not really available. But I think on the whole the performance has been disappointing. Because now two years and more after Bernanke came into office we don't see visible signs of change for the better.

For me, the failure to develop and quickly implement a plan for removing toxic assets from bank balance sheets has been the biggest policy failure. It's looking now like we may eventually get through this downturn without having ever put an effective toxic asset removal plan in place (though the administration claims they are still trying), and some contend that means we never needed a plan in the first place. But I disagree. We will never know the answer to this counterfactual, but I believe that if we had responded with a program quickly - a year and a half ago say and maybe even before that - I don't think the downturn would have been as severe. Yes, it's a hard problem to value these assets, but that's what made it essential to get it resolved - having assets on bank books that nobody wants anything to do with because their value is unknown is partly what has kept asset markets frozen (and banks that are allowed to overvalue these assets to appear solvent are in no hurry to get this resolved). Getting a toxic asset program in place quickly - even if it meant assuming some risk of losses by the government - would have made a difference.

Comments

[kingaj12:]

I have to say, with all due respect, that Anna Schwarz's observations on Bear Stearns and Lehman were much shallower than I would have expected given her reputation. This might lead one to reflect that, since she and Friedman were the academic inspiration for much of how the Fed operates monetary policy, it is perhaps hardly a surprise that we find ourselves in this kind of dilemma today.

Monetarism offers no guidance about systemic risk. Their argument that bailouts encourage bad behavior is inconsistent. Under the typical monetarist assumptions (EMH, etc) such risk-taking ought to have been curbed by investors fleeing their paper long before it became systemically important.

It is easy to construct a case that the attractiveness of monetarism to the political classes was the argument that unemployment was the fault of the unemployed and unionized labor rather than a symptom of an unstable economy.

Now that we have experienced two huge bubbles (internet and subprime) with no "external shocks", all under relatively conservative monetary policy, it is hard to deny that there is something about the financial system that monetarists do not understand.

What worries me and angers me the most is that it is quite likely that there is a lot that monetarists don't understand, and so the few policy levers admitted by this bankrupt economic theory are simply inadequate to finish the job.

Jun 10 05:04 PM

[Thomas J. G...:]

Someone should have asked Schwarz "If it's important to know how to price mortgage pools of various qualities, then why didn't the market figure out how do do that". Good article, she has a really important perspective, thanks.

Jun 10 06:37 PM

[John Galt:]

" When an economic historian comes in 25 years "

When an economic historian looks at what happened in 25 years, let's just hope this mess is way over. The great depression really lasted from 1929 until to the end of WWII.

Just don't forget that your parents and grandparents had leaders that were speaking of "green shoots" in 1929, 1930, 1931 etc. etc. etc.

Jun 10 08:31 PM

[Fighting Yoda:]

Fed created the mess in the first place by being asleep at the switch - when markets zoomed. Actually the maestro - Greenspan (the inventor of home ATM) cheered every bubble.

How terrible you can be with forecasts - the stress-free stress test adverse scenario was 9.2 - 9.6% (after upgrades) unemployment less than two months ago. Now even with all the 'green shoots' we are already at 9.4%. These guys are stupid morons - they need to be sent back to K-School.

After all the Trillion $ interventions and mortgage foreclosure moratoriums - the markets continue to crash, rates continue to rise. Nothing to show for all the Trillions wasted.

Let the free markets work - weak will perish, strong will thrive – it is too big, too complex, too interconnected – only the markets can figure it out – not bureaucrats.

Jun 10 08:46 PM

[redwine44:]

I am confused or else can't find the new news from Schwartz. Is this a new interview or a rehash of her interview last year? I can't find anything new on the web. The WSJ article by Carey (?) refers to her comments last year???

Jun 11 01:04 AM

[TinyTim:]

"...the Lehman Brothers bailout - she contends that the trouble started when the (ill-advised) rescue of Bear Stearns set up expectations that Lehman would be treated similarly - but if Bear Stearns or another large bank had been allowed to fail instead, I think we would have seen the same panic in financial markets."

I agree with you, the panic would have occurred if Bear failed. On the other hand, if the Feds rescued Bear & Lehman and kept it up with others, would the panic have still happened then? How about if they rescued three in a row to buy time to formulate a firm and publicized policy on toxic assets, then let a bank fail?

The thesis is that a failure of confidence in govt caused the meltdown. Expectations raise confidence. Uncertainty about what government might do lowers confidence. Greenspan practically raised this to an artform as policy. There were also rumors of personality and / or ideological issues between Lehman and Paulson. Certainly moral hazard was the buzz.

I think the housing bubble would have diminished in some way. The big issue is who pays for it. Until the billions in TARP rescue get paid back, the taxpayers are paying for it, in addition to all who took a bath on the MBS.

Despite the clarity of hindsight, I think history will show gross incompetence on the part of the Fed govt in not recognizing one bubble so soon after another. These guys are experts. They get paid not to be mesmerized.

Jun 11 02:01 PM

[kingaj12:]

I apologize for my flame above. Thomas Gordon's comment above was more appropriate.

Jun 11 02:11 PM