- The Washington Times - Wednesday, September 17, 2008



As of this Monday, United States Federal Reserve and Treasury Department policies have entered the presidential electoral political debate. While, as a rule, I am in favor of candidates for high office discussing policy, I am inclined to want to make an exception for these arcane, yet vital, policy zones. Not only do none of the four candidates know much about federal reserve policies, but even their advisors may not be amongst the very few experts in this arcane area.

But worst of all, the ambiguities and subtleties of such delicate financial crises management decision-making are singularly unable to be comprehended by slogans and phrases.

And yet, both the Obama and McCain campaigns jumped out of the box on Monday with the assertions that they didn’t want a tax-payer funded bailout, and they both called for comprehensive and tighter new financial regulations. I think I would rather have the candidates lying about each other’s character flaws than discuss Fed policy in public. I certainly don’t claim expertise, but let me point out a little bit of the history of the confusion.

Let’s go back for a moment to the alleged historic mother lode of hard-learned Fed policy wisdom - the Stock market crash of 1929 and the following Great Depression. Initially, in late 1929 and early 1930 the Federal Reserve did make major purchases of securities and cut the interest rate from 6 percent to 4 percent.

But by not bailing out banks in the three great runs on banks of late 1930, spring 1931 and March 1933 (resulting in 10,000 banks going out of business), Treasury Secretary Andrew Mellon’s famous (though not strictly followed) advice, “liquidate labor, liquidate stocks, liquidate real estate” became the prime example to history of what not to do during a financial panic.

And indeed, the lesson learned from those events has been that the Fed should make sure banks have enough reserves to cover deposits. Quick and sustained intervention has been the rule.

But if one listens carefully to the public comments of the last few months, one hears praise for at least the echo of an allegedly cold-hearted Mr. Mellon. As Treasury Secretary Hank Paulson said just this Monday: “Moral hazard is something I don’t take lightly.” This currently very popular proposition correctly observes that in free markets, investors who take undue risk must pay - and be seen to pay - the price for such improvidence. This proposition is undergirded by the famous maxim of Joseph Schumpeter that failure in the marketplace is part of the creative destruction of capitalism.

Or, as old Mr. Mellon said along with his liquidation trilogy: “Values will be adjusted and enterprising people will pick up the wreck from less competent people.” So, when do we let economic nature take its healthy course, and when do we intervene with taxpayer dollars to bail out large failing institutions? This week poor old Lehman Brothers was being cheered into bankruptcy by an unholy troika of commentators, experts and presidential candidates - as an example “pour encourager les autres” (the full quote from Voltaire - in translation, is “in England, it is good, from time to time, to kill an admiral, to encourage the others.”)

But only last week not only both candidates for president, but even such a free market man as Larry Kudlow called the tax payer backing of Freddie Mac and Fannie Mae ” a necessary action [to] stop a global money meltdown - but it raised the stakes for taxpayers once more.” And Kudlow - who I both admire and consider a friend - also backed the bailout of Bear Stearns in order to “safeguard the banking system and the whole global financial structure.” So slogans like no more tax payer bailouts are meaningless verbiage. (Although what is said in presidential campaigns can sometimes, if we are not careful, actually become government policy the following year.)

In fact, it is always a matter of nice judgment whether the system needs protection or whether it can withstand the tough but fair workings of the marketplace. This week the consensus judgment was that Lehman fell into the latter category. Time will tell because the markets and the public had to mentally absorb not only the Lehman bankruptcy, but the Merrill Lynch purchase by Bank of America and the possible fatal illiquidity of AGI, the insurance giant. The first reaction was a 504 point drop.

As I write, Tuesday markets are not yet closed. But it may be months before we know whether it was wise or foolish to “protect the taxpayers” last weekend.

But here is the kicker. About a year ago, the Fed held about $800 billion in securities to use to finance bailouts and for other purposes. As of this week they are down to about $475 billion in assets. If things get worse and persist, they may not have enough securities to act in the future.


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