Text size

ANNA SCHWARTZ, CO-AUTHOR WITH Nobel Laureate Milton Friedman of the seminal A Monetary History of the United States, has worked with the National Bureau of Economic Research since 1941, and remains an adjunct professor emeritus at the Graduate Center of the City University of New York. About to turn 93, she has spent most of her professional life studying how the changes in money supply interact with inflation -- both within the United States and abroad.

"The chief problem is that the Treasury can responsibly provide capital only to solvent institutions, but should not recapitalize insolvent institutions. The current program offers no way of determining who is solvent and who is insolvent," says monetary authority Anna Schwartz. Gary Spector for Barron's

When it comes to the unprecedented lending by the Federal Reserve Bank under Chairman Ben Bernanke and new and untested programs from the Treasury and its head, Henry Paulson, she doesn't like what she sees.

Her prescription: Stop managing by press release. The federal government needs to turn off the liquidity spigot and quarantine bad assets. Ad hoc program announcements have only undermined faith in the U.S. financial system, in her view, and, if continued, could raise fears that ultimately threaten the U.S. financial system. Here are more of her provocative thoughts on the current crisis.

Barron's: Professor Schwartz, what are your regrets about the government's handling of the credit crisis?

Schwartz: If I regret one thing, it's that Milton Friedman isn't alive to see what's happening today. It's like the only lesson the Federal Reserve took from the Great Depression was to flood the market with liquidity. Well, it isn't working. Professor Friedman would have enough stature to get them to listen and stop pooh-poohing any notion of possible inflation.

It is also regrettable that the Shadow Open Market Committee is no longer active. It was a group of private economists that until two years ago met semi-annually to comment on policy actions of the U.S. monetary authorities. If the group were issuing policy statements too, they would be providing the public with an independent judgment on the merits or shortcomings of the authorities.

So you find today's policymaking frustrating?

It's like there's a bunch of guys that are making it up as they go along. They talk about transparency and what they present is opacity, programs that don't make sense, or are not yet fully laid out. This only increases the already high level of uncertainty and anxiety.

Disclosure's a problem. With the bailouts of Bear Stearns, AIG, and the failure of Lehman Brothers, we have yet to receive a full explanation of the reasons for either rescuing the banks or, in the case of Lehman, letting them fail. Why did the Fed rescue Bear Stearns, yet let Lehman Brothers go under? There's clearly not enough disclosure to show if they are approaching the problem in a systematic manner or are playing favorites. Who knows? These unanswered questions only add to the fear in the system.

Accountability, or its absence, is a theme of yours.

Indeed. The Federal Reserve has used its balance sheet in ways never before seen, leveraging it by 25%. It now lends to banks and brokerage firms and companies in a series of programs ranging from the support of asset-backed paper, money funds, the London offices of Goldman Sachs, Morgan Stanley and Merrill Lynch, and also AIG. These programs come on top of the TARP [Troubled Asset Relief Program] passed in Congress this month.

Do you believe that the real problem comes not so much from troubled mortgages but the inability of banks to price securities they have created in the secondary market?

The problem comes from the introduction of new instruments and the difficulty in pricing these securities or pools of mortgages. The trouble is that mortgage pools are made of good, bad and insufficient mortgages, and it's hard to name a price. To make matters worse, the rating agencies were used to rate the securities. And they came up with ratings in an arbitrary manner without really doing due diligence. Now no one has any idea of how to price these securities. And the rating agencies are lowering the ratings on some of the instruments to which they have given top grade.

Another spinoff from mortgage-backed securities is credit-default swaps. There was no way of evaluating what effect a downturn would have on the derivatives markets and their counterparties. Few who deal in the derivatives market have a clear notion of their responsibilities. We have a bewildering array of instruments with uncertain prices. And as a result, we don't know who's solvent and who's not. The problem comes from a lack of ability to price the instruments, not a lack of liquidity. Evidence of the banks' unwillingness to lend can be seen in the most basic Federal Reserve statistics, which show that in the week ended Oct. 1, the banks had $167 billion of balances with the Federal Reserve, whereas on July 2 there was only $14 billion. Clearly the banks are holding the money and failing to pass it on in new consumer loans and business, preferring instead the safety of the vault.

So the trouble comes from not knowing the shape and size of the players and the exposures they have in various markets.

We also need to learn whether or not security holders are responsible for their counterparties.

How do you coordinate rescue programs both domestically and overseas?

We arguably have an obligation to help clean up Europe because we persuaded investors there to buy these securities, because of their high ratings, and they've been left high and dry. The Federal Reserve's recent creation of "unlimited" billions of dollars in currency-swap lines to central banks like the Bank of England, Bank of Japan, the European Central Bank and the National Bank of Switzerland helps in this regard.

These institutions arguably assist the various rescues without necessarily having to sell dollars to raise the available funds. But there's too little information about how these loans are being made. For what duration, and on what terms. Transparency will only serve to increase faith that the measures are occurring in the open.

But you contend that the most work needs to done on the Paulson plan.

The $700 billion Paulson package represents further problems because of the ad hoc way it seems to be cobbled together. Originally the hope was that the program could absorb all the bad assets on the balance sheets of banks so they could start over. No one has come up with an exact program for dealing with the bad assets once the Treasury buys them. How are they going to price the assets that the Treasury ultimately purchases? No one has come up with a way to price these new securities. Now, however, the bad-asset programs seem to have been set aside in favor of a program to recapitalize financial institutions.

But won't all these multi-billion-dollar programs in time create inflation?

Up until the middle of 2008 the Federal Reserve balance sheet had not experienced an annual growth rate well above the traditional 5%. Since mid-summer, Fed credit appears to have ballooned greatly, and that's behind the upward pressure in the consumer price index. The Fed pooh-poohs inflation because of a perceived slowdown in oil and gas prices. But theoretically any increase in the monetary base must be met with a tightening if inflation is to be avoided. Right now the Fed is pursuing a pro-inflation strategy by lowering interest rates and showering the banking system with liquidity. They're not even considering inflation. Paul Volcker learned that success in fighting inflation comes from tightening monetary policy, even if the public holds you responsible for disinflation.

Is there anything to like about the Paulson plan?

The first real positive sign was the original Paulson package. It seemed to be a move in the right direction. But it's been superceded and is short on specifics. How were they going to price these assets? Who were they going to hire to buy the assets for the federal government? Will they be friends of Goldman Sachs, BlackRock? There's precious little detail about how they're going about this plan. What about the chance of holdouts? And what does the government do with the paper once it buys it?

The way you clear up problems in the credit market is through coming up with a clear, understandable plan and then executing it precisely.

Just how high are the stakes?

My hope is that they will solve the problem by doing a bang-up job. But there's already been talk about having to come back for more money. The risk of being unclear and doing things ad hoc is that you gradually destroy faith in the financial system. And complete loss of faith leads to the imposition of a bank holiday, the closing down of the system, to reassure the public of the solvency of banks.

We're not there yet. But if we keep making things more uncertain, and feeding the fear without minimizing the problems, we could eventually make it so that Americans lose faith in their financial system.

The program now is to recapitalize financial institutions on the questionable premise that the accounting of potentially bad assets on the bank balance sheets is correct and accurate. The chief problem with this program is that the Treasury can responsibly provide capital only to solvent institutions, but should not recapitalize insolvent institutions. The current program offers no way of determining who is solvent and who is insolvent. We have a dilemma.

Thank you, Anna.