The government is trying to do the opposite of what it did the last time an economywide financial crisis rocked the country. So we will see if a vastly ambitious government expansion of money and credit can fix today's crisis. But it's a dangerous game, and far from assured.
During the Depression, policymakers stood by as banks failed and spooked savers hoarded dollars. The government, instead of expanding money and credit, allowedindeed, encouragedit to vanish from the economy.
Scholars, notably the late Milton Friedman, long ago convinced mainstream economic thinkers that this monetary blunder pushed the nation and the world into a long-term contraction during the '30s and kept it slumping for a decade.
So in the last few months, the government has embraced its traditional role of money creator and a brand-new role of direct lender of first and last resort to the private sector. It's unlikely that President Obama will mandate any change in philosophy.
The Fed has sloshed the economy with enough money that banks should theoretically lend to one another at a zero percent interest rate. These actions carry the grave risk of runaway inflation, but they aren't unorthodox.
But the Fed doesn't think that these old-fashioned methods are enough on their own to jump-start today's private credit markets. It can create the money, but the private infrastructure to get it where it needs to go to grease the economythe securitization marketsno longer exists.
The Fed thus finds itself stuck in a vicious loop: It can pump out money and cheap credit, but the banks, scared stiff by the poor decisions they've recently made in granting credit, will just lend it back to the government by buying safer Treasury bonds.
The Fed, of course, could just wait for its decisive traditional steps to have an impact. But it is risking more than a trillion dollars to shortcut this process.
The government's actions, in recapitalizing banks and guaranteeing their liabilities, and in trying to replace securitization markets, actually point out its limitations and the new dangers it is creating.
Consider that it's not just a lack of capital and fear of future losses that are keeping banks from stepping up and replacing the vanished securitization markets as the economy's credit creators (although those are good reasons).
Banks simply no longer remember how to be banksthat is, long-term direct lenders to customerssince the securitization markets have done that job for so long.
For the past decade, banks haven't served as credit analysts, assessing the capacity of people and institutions to repay debt based on judgments about personal and corporate income and character, and future economic growth.
Instead, banks served as financial engineers, making securities to sell.
Now that the securitization markets have dried up, what the government is asking the banks to do is like asking a hospital that delivers a newborn baby to raise him until he's 18 years old. But nobody in the private markets trusts the big banks suddenly to become excellent analysts of credit prospects.
And even if the banks do their best at the assignment, nobody has any real idea, after a decade of almost unimaginable credit distortion, of how much credit the economy can reasonably support.
When Giants Fall
If they're going to become long-term lenders again instead of short-term "securitizers," even relatively healthy big banks will need a quiet period to make the huge changes necessary for their new role. The government is asking too much in wanting them to circumvent this process and just start lendingand lending even more than they did back before the securitization markets replaced them.
Worse, the government's propping up of yesterday's banking giants, along with its creation of new banking giants through government-facilitated mergers, may inhibit a natural market correctionone our economy needs so we can maintain our global competitiveness in financial services.
In any industry, when a giant stumbles, a smaller company inevitably rises to take its placewhether it's Microsoft after IBM faltered or Google after Microsoft stumbled. Without artificial government support for the gigantic legacy banks, healthy, smaller banks could become the next kings.
Smaller banks could also drive the next generation of financial-services innovation. Yes, in the past, we got such innovation from today's big, brand-name banks. But today, with their government supportand whatever favors to the government are implied in returnthe legacy banks may become more like public utilities than entrepreneurial centers.
Ask yourself: How much innovation have you seen from Con Edison lately?
The government hasn't confined its furious credit-creation efforts to the banks, though. Realizing that banks simply can't take over the entire credit-creation function that the securitization markets once held, the Fed and the Treasury are now implementing a second radical innovation: devoting hundreds of billions of dollars to replace directly the vanished investors in those markets.
The government thinks it can create a synthetic, government-guaranteed version of the intricate infrastructure that was the private securitization markets.
But it could be retarding recovery. The securitization model failed. Private investors will no longer invest in these financial instruments for good reason: They don't trust the financial engineering behind them. It requires a suspension of disbelief to think that the government can fix this problem by replicating the same securitization model, even if it plays the role of biggest risk-taker.
Instead, private-sector entrepreneursincluding, optimally, people who weren't involved in creating the securitizations that failedmust painstakingly come up with new models to replace the discredited ones and thus help get credit from lenders to borrowers. But the government may overwhelm such innovation by trying to replicate the old, broken model.
It's similar to the government's bailing out GM at the expense of an upstart like Tesla Motors, which is hard at work building what it thinks are the American cars of the future. Trying to create capital, the government may end up starving good ideas, including good financial ideas, of capital.
The overriding danger with everything that the government is doing, though, is that there's no natural exit strategy.
While the Depression showed that a precipitous drop in money and credit is horrible, that doesn't mean that risking severe inflation at a time of economic weakness, maintaining failed ideas and breaking the national bank over some indeterminate amount of time to maintain an artificial level of credit, is better.
But there is hope.
Taxpayers Get It
First, market forces do still exist. The market has insisted, for example, against all odds, that Citigroup must split itself up.
Politics provides another cause for optimism. The public, though whipped into financial panic, has consistently opposed a year's worth of bailouts.
Taxpayers and the markets understand something viscerally that policymakers do not. The real lesson of the Depression may be that there is no straightforward policy fix for such an enormous mess.
As Lazard Freres partner Albert J. Hettinger, Jr., wrote in the original introduction to Friedman and Schwartz's masterpiece on the Great Depression's monetary blunders:
"High-powered money, intelligently administered by a regulatory body, can, as the authors point out, accomplish much. It cannot accomplish the impossible."
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