Sunday, October 19, 2008

When Good Decisions Make You Rich

The WSJ has an interesting piece on the VIEWS OF ANNA SCHWARTZ regarding the government's policy response to the financial crisis:
"To understand why, one first has to understand the nature of the current 'credit market disturbance,' as Ms. Schwartz delicately calls it. We now hear almost every day that banks will not lend to each other, or will do so only at punitive interest rates. Credit spreads -- the difference between what it costs the government to borrow and what private-sector borrowers must pay -- are at historic highs.

This is not due to a lack of money available to lend, Ms. Schwartz says, but to a lack of faith in the ability of borrowers to repay their debts. 'The Fed,' she argues, 'has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.'

So even though the Fed has flooded the credit markets with cash, spreads haven't budged because banks don't know who is still solvent and who is not. This uncertainty, says Ms. Schwartz, is 'the basic problem in the credit market. Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue.'"
The government's policy is off the mark because it seems to misunderstand the nature of the problem. In other words, it is like the government is treating symptoms and not causes.

If the government wanted to treat the causes, what would the policy look like?
. . . In fact, by keeping otherwise insolvent banks afloat, the Federal Reserve and the Treasury have actually prolonged the crisis. "They should not be recapitalizing firms that should be shut down."

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."
If the bottom line for this financial crisis is that lenders cannot get the information they need so they can figure out who is sound and who is likely to fail, then it seems to me the policy should be to let the troubled businesses fail because this is likely to be the most effective, maybe the only, way to figure out who is safe to lend to, i.e., the businesses left standing were not the troubled businesses.

There is a very sound principle, or perhaps moral to the story, found in the quote just above:
EVERYTHING WORKS MUCH BETTER WHEN WRONG DECISIONS ARE PUNISHED AND GOOD DECISIONS MAKE YOU RICH.
Of course, this is the way of capitalism and free markets. It most certainly is not the way of governments and public policy. For quite some time now government policy has intervened in mortgage markets, and the policies amounted to subsidizing risk taking in mortgage lending.

If we want to live by this principle, then shouldn't we also want to see those who were involved in making the bad policy decisions that "socialized" the risk "punished" as well? Congress bears responsibility for the bad policy decisions, and it seems there are specific leaders in Congress who were leading the charge to so many bad mortgages. How can these members of Congress bear the responsibility for their bad policies unless they are removed from Congress? Of course, it looks like this will not happen, and it also looks like we are likely to elect a new Congress and a new President in November, and relatively few of the newly elected will understand the wisdom of this principle.

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