Currency Wars_ The Making of the Next Global Crisis - James Rickards [90]
In the depths of the Great Depression, when this lender of last resort function was most needed, the Fed failed utterly. More than ten thousand banks in the United States were either closed or taken over and assets in the banking system dropped almost 30 percent. Money was in such short supply that many Americans resorted to barter, in some cases trading eggs for sugar or coffee. This was the age of the wooden nickel, a homemade token currency that could be used by a local merchant to make change for a customer and then accepted later by other merchants in the vicinity in exchange for goods and services.
The next time the lender of last resort function became as critical as it had been in the Great Depression was the Panic of 2008. The Fed acted in 2008 as if a liquidity crisis had begun, when it was actually a solvency and credit crisis. Short-term lending can help ease a liquidity crisis by acting as a bridge loan, but it cannot cure a solvency crisis, when the collateral is permanently impaired. The solution for a solvency crisis is to shut down or nationalize the insolvent banks using existing emergency powers, move bad assets to government control and reprivatize the new solvent bank in a public stock offering to new shareholders. The new bank is then in a position to make new loans. The benefit of putting the bad assets under government control is that they can be funded at low cost with no capital and no mark-to-market accounting for losses. The stockholders and bondholders of the insolvent bank and the FDIC insurance fund would bear the losses on the bad assets, and the taxpayers would be responsible only for any excess losses.
Once again, the Fed misread the situation. Instead of shutting down insolvent banks, the Fed and the Treasury bailed them out with TARP funds and other gimmicks so that bondholders and bank management could continue to collect interest, profits and bonuses at taxpayer expense. This was consistent with the Fed’s actual mandate dating back to Jekyll Island—to save bankers from themselves. The Fed almost completely ignored Bagehot’s core principles. It did lend freely, as Bagehot recommended, but it took weak collateral, much of which is still lodged on the Fed’s books. The Fed charged almost no interest instead of the high rates typically demanded from borrowers in distress. The Fed also lent to insolvent banks rather than just the solvent ones worth saving. The result for the economy even now is that the bad assets are still in the system, bank lending is highly constrained due to a need to rebuild capital and the economy continues to have great difficulty returning to self-sustaining growth.
When most urgently called upon to perform its lender of last resort functions, the Fed has bungled both times. First in 1929–1933, when it should have provided liquidity and did not. Then again in 2007–2009, when it should have closed insolvent banks but instead provided liquidity. The upshot of these two episodes, curiously, is that the Fed has revealed it knows relatively little about the classic arts of banking.
In 1978, the Humphrey-Hawkins Full Employment Act, signed by President Jimmy Carter, added management of unemployment to the Fed’s mandate. The act was an explicit embrace of Keynesian economics and mandated the Fed and the executive branch to work together in order to achieve full employment, growth, price stability and a balanced budget. The act set a specific numeric goal of 3 percent unemployment by 1983, which was to be maintained thereafter. In fact, unemployment subsequently reached cyclical peaks of 10.4 percent in 1983, 7.8 percent in 1992, 6.3 percent in 2003 and 10.1 percent in 2009. It was unrealistic to expect the Fed to achieve