In an October 2008 Wall Street Journal interview, Economist Anna Schwartz unloaded on the Committee to Save the Banks’ response to the acute phase of the Great Financial Crisis.  She accurately predicted their response of saving the banks would actually prolong the financial crisis and undermine the social contract.

So who was Anna Schwartz and why should macroeconomists, including those working at central banks, have listened to her then and over the last decade?

She’s not only old enough to remember the period from 1929 to 1933, she may know more about monetary history and banking than anyone alive. She co-authored, with Milton Friedman, “A Monetary History of the United States” (1963). It’s the definitive account of how misguided monetary policy turned the stock-market crash of 1929 into the Great Depression.

She was the expert or the closest to it the macroeconomics profession had on depressions in the US.

And what did she have to say?

The Fed 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….  Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.

And what is the source of this uncertainty?

Opacity.  Opacity that prevented the markets from assessing the risk and value of the  banks.  Opacity that prevented the markets from assessing the risk and value of subprime mortgage-backed securities and related derivatives these banks were exposed to.

But I am getting ahead of the story Ms. Schwartz was telling.

Today, the banks have a problem on the asset side of their ledgers — all these exotic securities that the market does not know how to value.

The market knows how to value, but it cannot value these securities or banks because of opacity.  An important point still missed by the macroeconomic profession.

Opacity hides the risk of these securities and the banks.  And it is this hidden risk that is toxic.

They’re toxic because you cannot sell them, you don’t know what they’re worth, your balance sheet is not credible and the whole market freezes up. We don’t know whom to lend to because we don’t know who is sound.

A nice summary of the opacity problem facing the global financial system in the fall of 2008.

Regular readers know that rather than respond to this problem by restoring transparency so investors could know what they own, the Committee to Save the Banks decided to bailout the banks.  Ms. Schwartz really disliked this policy response.

They should not be recapitalizing firms that should be shut down…. firms that made wrong decisions should fail.  You shouldn’t rescue them. And once that’s established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich…

It’s very easy when you’re a market participant 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, just as it didn’t save the stockholders and the employees of Bear Stearns. 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.”

Ms. Schwartz understood bailing out the creditors rewrote the social contract.  Before the creditors were saved in 2008, it was understood they were responsible for losses on their lending and investment decisions.  This made sense as it instilled discipline on the creditors to take care and not lend more than a borrower could afford to repay.

With the bailout of the creditors, suddenly it was the borrowers who bore the brunt of the creditors bad investment and lending decisions.  Think 9.3 million home foreclosures.  With each foreclosure, the social contract and respect for the institutions of government evaporated.

Ms. Schwartz continued:

I think if you have some principles and know what you’re doing, the market responds. They see that you have some structure to your actions, that it isn’t just ad hoc — you’ll do this today but you’ll do something different tomorrow. And the market respects people in supervisory positions who seem to be on top of what’s going on. So I think if you’re tough about firms that have invested unwisely, the market won’t blame you. They’ll say, ‘Well, yeah, it’s your fault. You did this. Nobody else told you to do it. Why should we be saving you at this point if you’re stuck with assets you can’t sell and liabilities you can’t pay off?’

This is another very important point missed by the macroeconomics profession.  Our financial system was designed to support the response of making the creditors realize their losses.  This was particularly true for commercial banks.  The combination of deposit insurance and the Fed as a lender of last resort meant commercial banks could protect borrowers and the real economy by recognizing their losses today.  Even if recognizing their losses made them insolvent, access to funding from the Fed meant these insolvent banks could continue to operate and support the real economy until such time as the bank regulators closed them.

Instead, the Committee to Save the Banks pursued policies to hide the underlying problems.  As she observed,

In general, it’s easier for a central bank to be accommodative, to be loose, to be promoting conditions that make everybody feel that things are going well.

In pursuing easier policies like zero interest rates and quantitative easing, the Fed generated a number of adverse side effects.  For example, we have seen the rapid growth of zombie companies.  These are companies who don’t make enough to repay their debt.  Their ongoing existence undercuts the economics of the industry they are in.

Ms. Schwartz offered up her conclusion on the policies to save the banks and hide what was happening.

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.

History agrees with her.   A decade later, former Fed Chair Paul Volcker’s observation “we’re in a hell of mess in every direction” confirms she was right.