Anna Schwartz blames Fed for sub-prime crisis

By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, January 13, 2008

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/01/13/ccschw...

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

The high priestess of US monetarism -- a revered figure at the Fed -- says the central bank is itself the chief cause of the credit bubble and now seems stunned as the consequences of its own actions engulf the financial system.

"The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

"They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence," she told The Sunday Telegraph.

"There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for," she says.

Schwartz remains defiantly lucid at 92. She still works every day at the National Bureau of Economic Research in New York, where she has toiled since 1941.

Her fame comes from a joint opus with Nobel laureate Milton Friedman: "A Monetary History of the United States." It revolutionised thinking on the causes of the Great Depression when published in 1965. The book blamed the Fed for causing the slump. The bank failed to use its full bag of tricks to stop the implosion of the money stock, and turned a bust into calamity by raising rates.

"The book was a bombshell," says British monetarist Tim Congdon. "Until then almost everybody thought the free-market system itself had failed in the 1930s. What Friedman-Schwartz say was that incompetent government bureaucrats at the Fed had caused the Depression."

"It had an enormous impact in revitalising free-market conservatism, and it broke the Keynesian stranglehold over policy," Congdon says. Keynes himself was a formidable monetarist. He became a "Keynesian" big spender only once all else seemed to fail.

The tale of the early 1930s is intricate, but worth rehearsing in the climate of today's credit crunch.

The October 1929 crash did not cause the slump; it was merely a vivid detail. The US economy muddled through for another year, seemingly sound. Then it buckled as rising defaults in the farm belt set off a run on local banks.

It was at this juncture that, critics claim, the Fed lost the plot. Washington prohibited the pros at the New York Fed from injecting sufficient stimulus through open market operations -- buying bonds.

Contagion spread. The Jewish-owned Bank of United States was allowed to collapse by fellow clearing banks, for reasons of snobbery and malice.

The Chicago Fed insisted into the depths of the deflation that inflation still lurked, that there was an "abundance of funds," that speculators had to be punished, and that bad banks should fail. The staggering blindness of Fed backwoodsmen from 1930-1933 is hard to exaggerate.

In hindsight it seems astonishing that the Fed raised the discount rate twice in late 1931 to 3.5 per cent even as global finance was disintegrating. It did so to halt bullion flight and defend the gold standard but it failed to offset the effects with bond purchases. Britain was forced off the gold standard in September 1931 after the Atlantic Fleet "mutinied" at Invergordon over 10 per cent pay cuts. That proved a providential crisis -- the pound fell. The Bank of England was soon able to slash rates. The slump proved less serious than in the US, and not a single bank collapsed in the British Empire.

Schwartz warns against facile comparisons between today's world and the gold standard era. "This is nothing like the Depression. I don't really believe the economy as a whole is going to fall apart. Northern Rock has been the only episode of a bank failure so far," she says.

More than 4,000 US banks -- a fifth -- collapsed in the 1930s. There was no deposit insurance. Real economic output fell by a third, prices by a quarter, and unemployment reached a third. Real income fell by 11 per cent, 9 per cent, 18 per cent, and 3 per cent in the years to 1933.

According to Schwartz the original sin of the Bernanke-Greenspan Fed was to hold rates at 1 per cent from 2003 to June 2004, long after the dotcom bubble was over. "It is clear that monetary policy was too accommodative. Rates of 1 per cent were bound to encourage all kinds of risky behaviour," Schwartz says.

She is scornful of Greenspan's campaign to clear his name by blaming the bubble on an Asian savings glut, which purportedly created stimulus beyond the control of the Fed by driving down global bond rates. "This attempt to exculpate himself is not convincing. The Fed failed to confront something that was evident. It can't be blamed on global events," she says.

That mistake is behind us now. The lesson of the 1930s is that swift action is needed once the credit system starts to implode: when banks hoard money, refusing to pass on funds. The Fed must tear up the rulebook. Yet it has been hesitant for three months, relying on lubricants -- not shock therapy.

"Liquidity doesn't do anything in this situation. It cannot deal with the underlying fear that lots of firms are going bankrupt," Schwartz says. Her view is fast spreading. Goldman Sachs issued a full-recession alert on Wednesday, predicting rates of 2.5 per cent by the third quarter. "Ben Bernanke should be making stronger statements and then backing them up with decisive easing," says Jan Hatzius, the bank's US economist.

Bernanke did indeed switch tack on Thursday. "We stand ready to take substantive additional action as needed," he says, warning of a "fragile situation." It follows a surge in December unemployment from 4.7 per cent to 5 per cent, the sharpest spike in a quarter century. Inflation fears are subsiding fast.

Bernanke insists that the Fed has leant the lesson from the catastrophic errors of the 1930s. At the late Milton Friedman's 90th birthday party, he apologised for the sins of his institutional forefathers. "Yes, we did it. We're very sorry. We won't do it again."

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