Views on what the Fed should have done
He asks:
My question for Tyler: which of these views [Friedman and Schwartz vs. Bernanke as practitioner] do you think is correct?
Also, a related question, do you see any distinction between propping
up particular banks and reflating the system as a whole?
Our substantive discussion has really involved two interrelated
issues: what Milton Friedman believed and what is the proper policy in
the face of a potential financial panic. Friedman obviously modified
his views over time, becoming more libertarian, and it may be true that
the early Friedman might have accepted direct bailouts as a stopgap
MEANS of preventing monetary contraction. But I do not believe that the
logic of Friedman's monetarist business-cycle theory requires direct
bailouts. Would Tyler agree?
Two years ago, my view was this: if there is a banking crisis, the Fed should be loose with money and let the market sort out which banks deserve support and which do not. And stop there. When Bernanke let Lehman go, I remember being happy and thinking he finally had "real guts." I now view that attitude as mistaken, as I had not forecast how badly some credit markets would freeze up, most of all the collapse of repo as analyzed by Gary Gorton. Two years ago I also had not imagined that the U.S. economy could end up with so many insolvent banks at once. I had thought that the presence of "real money on the line," from bank CEOs, would stop such an outcome. That was wrong too.
When I perused Friedman's writings lately, I found that, as far as I could tell, he never discussed how to deal with widespread bank insolvency. I interpret him as believing that LLR and loose money and the FDIC could deal with banking crises; furthermore over time his mix of this recipe became successively more libertarian and less interventionist, as David mentioned. But I also think that perhaps he, like I, hadn't imagined that the insolvency problem would take on the breadth and depth it did. (Note that although he became more libertarian about the present, he never repudiated his previous call for Fed activism during the GD.)
On the right and wrong of the matter I side with Bernanke and the bailing out of at least some of the insolvent banks. I also think that the more modest Friedman recipe is still fine for most "panics," just not this one.
I side with Bernanke because an economy can withstand only so much major bank insolvency at once. Lots of major banks were levered up 30-1 or so. Their assets fell in value more than a modest amount and then they were insolvent, sometimes grossly so. (A three percent decline in asset values already puts you into insolvency range.) If AIG had gone into bankruptcy court, some major banks would have been even more insolvent. Or if Frannie securities had been allowed to find their non-bailout values. My guess is that at least 15 out of the top 20 U.S. banks would have been flat-out insolvent if, starting at the time of Bear Stearns, all we had done was loose monetary policy and no other bailouts. Subsequent contagion effects, and the shut down of short-term repo markets, and a run on money market funds, would have made even more financial institutions insolvent. The world as we know it then becomes very dire, both for credit reasons and deflation reasons (yes you can print up currency to keep measured M up and running but the economy still collapses). So we needed not just emergency lending but also resource transfers to banks, basically to put them back into the range of possible solvency.
I can imagine some responses to this:
1. My sense of the numbers is wrong and, without bailouts, very few banks would have become insolvent. There would have been another Lehman or two but pretty soon the dust would have settled and we would be back to where we are now, albeit with weaker moral hazard problems in the future because we taught a bunch of banks and their creditors a lesson.
2. The current status quo is so, so bad that it is worse than most major banks going insolvent and into bankruptcy court and the economy collapsing.
3. We can have most of the major banks, insolvent and in bankruptcy court, without the economy collapsing.
Any one of these would prove me wrong. But the other responses I see in the blogosphere mostly pick up on other tacks, usually citing defects in my understanding.
If you disagree with me on bailouts, a simple starting question is this: without the bailouts, and with loose monetary policy only, how many of the twenty largest banks do you think would have ended up in bankruptcy court within a fairly narrow time span? Until you've addressed that question, we're not getting to the bottom of the substantive issue. I should add that I've put this question to some serious anti-bailout thinkers and I am still waiting to hear back from them. It is my belief that they never framed the issue that way in the first place.
Believe me, I would be quite happy if I could go back to my previous "minimalist" views. But I find that when I ask myself this question about the number of insolvent major banks, and the economic and political consequences of that, I can't.
Addendum: Here is a recent piece on how Milton Friedman's views have been cited, borrowed, and criticized in the recent crisis. Arnold Kling comments.