WEALTH

MACRO
to 2007 encouraged a belief in stability that lulled
complacent policymakers and regulators into ignoring the
dangers of dubious practices that set up a fragile and
unstable financial system.
“The other thing worth observing,” Eichengreen says,
“is that it is also remarkable that we weren’t more aware of
those parallels and their implications – that it could all end
horribly – while they were unfolding.”
What went wrong? “I think the big mistakes, the major
examples of wrong lessons, were the decisions made before
the recent crisis.” These included the failure to strengthen
financial regulation and deal with the derivatives problem;
the dismantling of Glass-Steagall in the United States; and
the enthusiasm for light-touch regulation.
HISTORY SURE CAN RHYME
Yet if mistakes were made before 2008, decisions made that
year show that if history does not repeat, it sure can rhyme.
While the Fed rescued the investment bank Bear Stearns,
much as the interwar Fed had done for the Central Republic
of Chicago, it balked at bailing out Lehman Brothers, just as
in 1933 it chose to make a statement by letting Henry Ford’s
Union Guardian Trust of Michigan go under.
“One might think that this history would have informed
decision-making,” Eichengreen writes. “In the heat of the
moment, it did not.” In the case of Guardian Trust, that
created long lines of depositors clamoring outside banks
across the United States, and sent the financial system into
free fall.
“Recent decision-makers were blindsided by history,”
he told PROJECT M. “History informed their decisions
of how to respond but it also blinded them to risks that
had no parallel.”
Eichengreen argues that the single most influential
analysis of the Depression was A Monetary History of the
United States, 1867–1960, written in 1963 by Nobel Prizewinning
economist Milton Friedman and Anna J. Schwartz.
Their 110-page chapter on the 1930s focused on the collapse
of the banking system that made the Depression “Great.”
For Eichengreen, policymakers interpreted Friedman
too literally. The problem of retail bank runs had been
solved, thanks to the 1930s innovation of deposit insurance,
so the panicked bank runs of the Great Depression could be
avoided. But by focusing on monetary supply and banking,
modern policymakers missed the dangers lurking in the
shadow banking system (hedge funds, money market
mutual funds and commercial paper issuers) until too late.
“There was no significant shadow banking in the
1930s, so Friedman and Schwartz didn’t emphasize it,” he
explains. When Lehman failed, money market funds
holding short-term notes suffered runs by frightened
shareholders. Large investors then made runs on the
money funds’ investment bank parents, leading to the
collapse of the securitization market. This caught
policymakers and central bankers totally off guard.
When the markets imploded, unlike in the 1930s,
governments realized they were on the brink of depression,
so they quickly intervened. They ramped up massive
programs of fiscal spending, and central banks flooded
markets with liquidity until a semblance of economic
normality returned. A catastrophic worldwide depression
was avoided, but is collegial backslapping justified?
Eichengreen doesn’t believe so, arguing that the
interventions were far less effective than they could have
been. Post-crisis recovery in the US has been disappointing
by any measure, while Europe experienced double-dip
recession and a series of renewed crises starting in 2010.
But because the recent crisis was less severe than the
Depression, at least in the US, bankers have also been able
to resist making radical reforms, leaving the world
vulnerable to new financial shocks. “Success,” he concludes,
“was also the mother of failure.”
What is needed, as Eichengreen summarized to
PROJECT M, is to require banks, especially big ones, to hold
significantly more capital. He also argues that the conflict
of interest of credit rating agencies – acting as advisor on
how to obtain Triple A ratings and also conferring them –
has to be resolved.
Shadow banking remains a threat. Risks have been
moved into clearinghouses, but concentrated rather than
eliminated. “Moving derivatives onto electronic exchanges
where they can clear as soon as they are done is what
is needed,” he states. “And if some derivatives are too
complicated, too complex, too exotic, too thinly created to
be moved onto exchanges, then it is a good argument for
regulating them out of existence.”
So, what of the future? Eichengreen eschews the notion
of “lesson” when it comes to history, but if the past holds a
parallel relevant for the Fed today, it comes not from the
1930s, but from 1929. That year, concerned about excess on
Wall Street, the Fed raised interest rates to deflate the
bubble. It succeeded beyond expectations, setting up
conditions for the Great Depression.
“If you are concerned about deleveraging, imbalances
and excessive risk taking in the financial sector, there
are instruments better suited for addressing those
risks,” he says. “That is regulation, what is called macroprudential
policies, where regulators clamp down on
margin purchases of securities on risky lending.
Raising interest rates increases the danger that the
economy will tank. It is what the Fed did in 1929 and what
the Fed should avoid today.”
56 • Allianz