Monday, May 12, 2008

The Federal Reserve, the European Central Bank and the Swiss National Bank have jointly announced an expansion of liquidity measures to combat the global financial crisis triggered by the U.S. subprime mortgage meltdown.

The Federal Reserve will increase to $75 billion the amount auctioned biweekly to eligible depository institutions. Its Open Market Committee will let primary dealers pledge AAA/Aaa-rated asset-backed securities, in addition to already eligible residential- and commercial-mortgage-backed securities and agency collateralized mortgage obligations, in Schedule 2 Term Securities Lending Facility auctions. Earlier, the Bank of England announced a new “special liquidity scheme,”which enables banks to offload certain mortgage-backed securities in exchange for Treasury bills for up to three years. The aim is to get money flowing to support needed economic activity.

Yet, many “free market” purists oppose such policies. Conservative sage George Will has even called it “socialism.” Such critics would do well to read the late capitalist guru and Nobel economist Milton Friedman’s criticism of the Federal Reserve’s “inept” failure to act when the economy was sliding into the Great Depression.

Mr. Friedman’s monumental “A Monetary History of the United States,” written with Anna Schwartz, makes the now standard interpretation of what made the “great contraction” so severe. It was not the downturn in the business cycle, trade protectionism or the 1929 stock market crash that plunged the country into deep depression. It was the collapse of the banking system during three waves of panics over the 1930-33 period. Some 9,000 banks closed during those years, wiping out one third of the nation’s money supply.

The failure of the Bank of the United States on Dec. 11, 1930, the largest bank to collapse in U.S. history, was the result of the unwillingness of the Federal Reserve and the private Clearing House banks to save it. The shock it sent through the system was what today’s Fed Chairman Ben Bernanke wanted to avoid by heading off the collapse of Bear Stearns.

In the weeks after the failure of the Bank of the United States, the New York Fed made open market purchases from two other major banks to head off runs. But this was not the kind of vigorous policy the Federal Reserve as a whole was willing to embrace.

As Friedman recounts, “In 1930, New York strongly favored expansionary open market operations, but after the middle of the year was unable to persuade either the other Bank governors. … or the Board in Washington.” President Herbert Hoover lamented, “I concluded [the Federal Board] was a weak reed for a nation to lean on in a time of trouble.”

The Fed’s failure led to creation of the private National Credit Corp., a bank cooperative to extend loans using collateral not ordinarily acceptable. This effort failed. Next came the government’s Reconstruction Finance Corp. in January 1932 with the authority to make loans to banks, other financial institutions and railroads as a substitutes for a Federal Reserve that was refusing to do its job. No advocate of Big Government, Mr. Friedman could nevertheless declare “that different and feasible actions by the monetary authorities could have prevented the decline in the stock of money — indeed, could have produced almost any desired increase in the money stock.”

So why did the Fed fail to do what it was originally established to do, protect the financial system? Mr. Friedman cites the attitude of its governors: “They tended to regard bank failures as regrettable consequences of bad management and bad banking practices, or as inevitable reactions to prior speculative excesses, or as a consequence but hardly a cause of the financial and economic collapse in process.” Mr. Friedman called this a “confused and misguided” attitude, though one often voiced again today — and with more justification.

Today’s financial turbulence is different than what hit the country in the 1930s, but the principle remains valid. The government has a responsibility to take action to shore up the financial system when it threatens to implode. Mr. Friedman took his thesis beyond the Great Depression when he cited with favor how the British Panic of 1825 was combated. “We lent it,” said Jeremiah Harman on behalf of the Bank of England, “by every possible means and in modes we have never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank.”

Today’s Federal Reserve and other financial authorities are trying to be just as creative and responsible in heading off the Panic of 2008.

William Hawkins is senior fellow at the U.S. Business and Industry Council in Washington, D.C.

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