Legendary economist and former Milton Friedman partner, Anna Schwartz says Bernanke is attacking the problem at hand incorrectly. Schwartz says this is a crisis of trust, not liquidity.
Bernanke is right about the past, Schwartz says, “but he is fighting the wrong war today; the present crisis has nothing to do with a lack of liquidity.” President Obama’s stimulus is similarly irrelevant, she believes, since the crisis also has nothing to do with a lack of demand or investment. The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz. Lenders aren’t lending because they don’t know who is solvent, and they can’t know who is solvent because portfolios remain full of mortgage-backed securities and other toxic assets.
To rekindle the credit market, the banks must get rid of those toxic assets. That’s why Schwartz supported, in principle, the Bush administration’s first proposal for responding to the crisis—to buy bad assets from banks—though not, she emphasizes, while pricing those assets so generously as to prop up failed institutions. The administration abandoned its plan when it appeared too complicated to price the assets. Bernanke and then–Treasury secretary Henry Paulson subsequently shifted to recapitalizing the banks directly. “Doing so is shifting from trying to save the banking system to trying to save bankers, which is not the same thing,” Schwartz says. “Ultimately, though, firms that made wrong decisions should fail. The market works better when wrong decisions are punished and good decisions make you rich.” She’s more sympathetic to Treasury secretary Timothy Geithner’s plan, unveiled in March, to give private investors money to help them buy the toxic assets, but wonders if the Obama administration will continue to support the plan if the assets’ prices turn out to be so low, once investors start bidding for them, that they threaten the banks.
I think Schwartz is making the same mistake that most economists are making. They are too focused on the banks and lending rather than the consumer. This is a consumer driven problem. Not a bank driven problem. This problem all arose from a weak consumer who could no longer service mortgages that they had taken out. Banks are perfectly willing to lend. The problem is that consumers don’t want to borrow and can’t afford to service their debts.
Schwartz indicts Bernanke for fighting the wrong war. Could one turn the same accusation against her? Should we worry about inflation when some believe deflation to be the real enemy? “The risk of deflation is very much exaggerated,” she answers. Inflation seems to her “unavoidable”: the Federal Reserve is creating money with little restraint, while Treasury expenditures remain far in excess of revenue. The inflation spigot is thus wide open. To beat the coming inflation, a “new Paul Volcker will be needed at the head of the Federal Reserve.”
I don’t necessarily agree with the inflation outlook although my deflationist outlook has moderated quite a bit after the substantial price deterioration we’ve seen. In order for inflation to pick up we must see a pick-up in the velocity of money and that begins with the consumer. I’ve written on this previously:
The velocity of money must pick up in order for inflation to ensue. As of now we are seeing no signs of that. An easy way to visualize the velocity of money is this: imagine a pitcher of water. Now add a packet of iced tea mix. This is essentially what the Fed has done (except they’ve added about 10 times more mix than the back of the package instructs). Now, all that iced tea mix is just sitting at the bottom of the pitcher unused. You don’t get inflation (iced tea) until you stir in the iced tea mix. This is the velocity of money in action (in a very dumbed down example). We won’t get inflation until consumers begin borrowing and effectively stir in the iced tea mixture.
The real risk to the economy is not a zombie banking system, but a zombie consumer. Your government wants you to believe that the banks are the centerpiece of this crisis, but in reality it is you and I that are the centerpiece. Unfortunately, our banking system is built on lending and perpetually growing the debt in the system. But you won’t hear that from the bankers or else you might stop taking out those loans that keep them in business….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.