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.


Tyler wrote:

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.

Well, not to kick a dead horse, but if you hadn't found him ever discussing it, I wonder why you said with such confidence in your original post:

By the way, some libertarians like to pretend that Milton Friedman blames the Fed for "contracting" the money supply by one-third in that period but in reality Friedman blames the Fed for having let the money supply fall by one-third and not having run a bank bailout.

So did you really mean to write, "Some libertarians like to pretend that Friedman explicitly denied the efficacy of a bank bailout, when in reality he didn't say anything about it"? :)

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Ya know what T? I really don't think he can.

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Tyler makes a list of how libertarians might respond to what he says.

I don't have strong views on the matter, but I do think he needs a fourth on the list, something like the following:

4. The economy does collapse, and for the time being it is much, much worse than today. But even if the collapse itself means several very bad years, that is may not be all that significant in relation to the political and cultural changes that ensue. It is possible that the ensuing changes roughly take the form of "cleaning house." Maybe the crisis leads to a significant long-term reorientation toward classical liberalism, and therefore betterment for humanity, in the very long view.

I'm not saying that I think that, but I would put a positive (conditional) probability on it. Maybe many libertarians have the probability fairly high.

In other words, a really big component of the judgment is the "What happens politically and culturally?" question.

I believe that Tyler is very pessimistic about what happens in that scenario, and that is really where a lot of the differences in judgments lie.

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Why can't lending at penalty rates combined with regulatory leniency work for insolvent institutions? They'll eventually go bankrupt, but this would put off the day of reckoning a while and allow for orderly renegotiation and trading of claims and such.
If the placement in the capital structure is done right, depositors wouldn't be hurt, and we wouldn't lose money on the deal.

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Having been uncomfortably close to the situation last fall, I side with Tyler in the assessment that failure of the major banks and, with them, the payments system, was proximate and there really was no better means to avoid this than the course taken by the Fed. Bernanke and Paulson delivered about the best possible outcome and are the heroes of the crisis.

Now, the fact that we were that close to the green paper in your wallet reverting to mere green paper is not a good thing, and it behooves us to fix structures to reduce this risk in the future.

Daniel Klein's comment is worth considering as to the duration and severity of the "several very bad years". Predicting the Enlightenment 1000 years down the road would not be a great rationalization for allowing the sack of Rome to proceed. Specifically, I'd look to the odds that a collapse of the payment system would sufficiently disrupt the production and distribution of oil and, in turn, food, to cause severe famine in the developed world (with concomitant issues in the remainder). It seems hard to get to a positive value to the non-marginal revolution in that case.

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The government regulates the fractional reserve system. This system of money expansion is the same one that allows contraction. True you can't expand money with a gold standard, but you probably can't contract it as quickly. And, without expansion under a gold standard you can't as easily have bubbles due to easy money.

I'm not making the case for a gold standard. I'm asserting that the government created the environment that necessitates their intervention to save their most regulated industry. They made the weather and they say "shoot, it's rainin'" to paraphrase the character in Cold Mountain for a family blog. They also didn't have to do things the way they did and there are obvious ways to handle them better than by passing through money directly to Goldman Sachs on the one hand while at the same time imposing compensation "guidelines" with the other. Now, the banks are acting like not banks to get out from under the TARP trap, so not only could we have done it differently, we can still do it differently.

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"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? "

Let's assume all 20 failed, because if they needed fed money to stay alive, they had already failed. Has such a disaster happened before in US history? Yes, many times. Tyler seems to be completely ignorant of US financial history. We enjoyed at least a dozen depressions from 1800 to 1929 in which hundreds of banks failed, failures at least equivalent of the top 20 US banks today failing. Did Armaggedon happen? Did civilization end? No. So what did the Feds accomplish by bailing out banks? The took the future prosperity of our children and spent it so that we wouldn't have to suffer the consequences of our own stupidity. Very noble, huh?

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I'm very much of a my with Andrew and Dave on this. In particular, I object strongly to the apparent premise of your question, that the Fed's actions prior to Q3 last year are to be assumed.

1) The Fed could have, and should have, warned congress that the creation of a multi-tiered lending market was bad policy. (The Community Reinvestment Act, passed under Carter.)
2) In the aftermath of the S&L crisis, the Fed could have, and should have, communicated the dangers of a multi-tiered lending market, addressing specific programs (such as the CRA).
3) Under Clinton, the Fed could have, and should have opposed the expansion of the CAR, using the S&L crisis as an example.
4) The Fed could, and should, be regularly monitoring lending practices (both internally and externally), and responding accordingly.
-- Specifically, in 2005, while making $78k/yr, I was encouraged to apply for a jumbo loan (those started at $320k).
5) The Fed chairman could have, and should have given an "Irrational Exuberance" speech in 2005.

But ignoring all that, I'm sure that at 4:61 on September 31, the Fed did EXACTLY the right thing. For one minute, anyway.

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If anyone is still reading, I really think Tyler is contradicting himself here. I explain in this blog post. I will no longer argue with him on this, since either (a) he keeps flip-flopping or (b) I am a dense jerk. (And yes, [c] all of the above is also a possibility.)

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Many of the current problems are structural. The final collapse of a weak auto industry. The strain of a war. A price shock from a bump in oil prices. A threat of increased taxes and the expansion of government under a new administration.

All of these would have caused a serious recession without the housing bubble.

I would have preferred the Mankiw approach of a rapid temporary cut in payroll taxes. A nice way to helicopter in money. Or any number of general tax cuts rather then cash for clunkers or credits for home buying.

Friedman would clearly have opposed the stimulus bill.

He would have needed to address the pricing problem of toxic assets. I assume his solution would have been simple and elegant and based on the market clearing. The path we took encouraged banks to game the system and drag out the process.

I don't think that Friedman could have imagined that the pricing of assets would deviate so far or that financial institutions would take so much risk. (For the minute ignore the moral hazard of government policies that might contribute to the problems.)

He would have warned about the danger of higher taxes and greater regulation coming from Washington. We are lowering potential GDP. We are headed for a new period of stagflation: lower output at a higher price level.

The economy is still struggling with the ripples of the auto contraction. We need to deal with an aging population and the social net they were promised. Productivity in manufacturing will not support current wages. We have many sources for the current economic problems.

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Maybe the crisis leads to a significant long-term reorientation toward classical liberalism, and therefore betterment for humanity, in the very long view.

Are you kidding? How can you possibly believe this? The crisis, as it is, has already led to a sudden and scary turn *away* from capitalism and classical liberalism. Had the crisis been worse, I'm sure this effect would have been stronger.

But regardless, you seem to be arguing that following ideology A (classical liberalism) is good because as a consequence, more people might be convinced to follow ideology A. This doesn't establish why ideology A is a good thing (which I don't argue with, I am a fan of classical liberalism myself). But here's my problem with this argument, and any argument that says "let them go bankrupt. sacrifice now, and teach us a lesson." I think it's quite clear that the magnitude of disaster that would have occurred without "bailouts" would easily compete with or even outdo the depression. This self-inflicted punishment would have long-lasting and unknown effects on the economy, culture, civilization, and attitudes toward capitalism. I know, I know, we are less capitalist now anyway and all that, but I'd still take that over guaranteed depression. Sorry. The crisis was there; I'll take my chances with what we've got now. Maybe in a few years it all happens again, due to moral hazards. I'm hoping for some reform that keeps the "too-big-to-fail" problem under control.

It all sucks, but I think we've managed to muddle through pretty well so far. Time will tell.

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m writes: "Our banking system's problem is that government bailouts have become endemic to the way the system operates, so the traditional means of dealing with bank failures will lead to total financial collapse."

Actually, that isn't true. The number of banks bailed out was small, the number of banks that got capital infusions was inflated to conceal the ones that were really risky to prevent runs on and cause them to fail - this was like FDR closing all the banks and the reopening three quarters of them after a week, too soon to have actually checked them to be sure they were sound.

The number banks that are being taken over is very high, tho still lower than the BANK (not thrifts) failures in the S&L crisis. As the large number of bank failures wiped out a lot of stockholders, it isn't like stockholders expect to be bailed out.

The problem today, unlike in the early 90s, is the lack of well capitalized regional banks to buy the failed banks. The Fed is now having to loosen its standards for banks that are taking over the banks FDIC has seized, recently allowing what seem to be two foriegn hedge funds to bid on US banks.

Of course, the banks insured by the FDIC can be seized and put into receivership without bankruptcy court involvement and no interruption in access to accounts up to the insured limit.

For the Lehman and Bears' bankruptcy filings would have frozen all deposits. And they were part of a "free bank" system where money market funds provided the demand savings and checking using the money created by Goldman and Lehman and Bear. Remember when one of those "free banks" suffered a bank run, Reserve Primary Fund, and it had to close, and that threatened to trigger runs on all the other "branches" of the shadow "free banks."

I find it bizarre that this crisis has revived the call for getting rid of the Fed and replacing it with "free banking" when this crisis was caused by "free banking" in an interlocking, distributed managed, network of departments creating money and branch providing the demand deposit accounts, and then all these parts engaging in the overnight interbank operations that are managed between Fed member banks and too the Fed when they can't meet reserves otherwise.

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fuck this thing
too long

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